A little less than a year ago, I wrote an article titled "Cap Rates and Growth — What the heck is going on?" I had been thinking about the relationship between cap rates, expected growth and required returns. I noted the deceptive similarity between the most commonly used formula in real estate investing:
Value = NOI / Cap Rate
and the equally omnipresent perpetuity formula that is at the heart of corporate valuation:
Value = Cash Flow / (r − g)
It was not a huge jump in logic to conclude that: Cap Rate = r − g
But I also pointed out some apparent inconsistencies in the literature. There was the rule of thumb that the going-in cap rate plus growth in NOI equals the unlevered return. There was also the argument that, at least in stabilized real estate, incremental investment typically does not earn more than the cost of capital. Consequently, growth doesn't create much value, and therefore for practical purposes, you can largely ignore it.
How do you reconcile these disparate views? I suppose I accepted the argument that incremental investment in stabilized real estate rarely earns more than the cost of capital. Taken together with the mantra of corporate finance that growth only creates value when the ROIC > WACC, I was prepared to dismiss growth in revenue and even NOI in this asset class. From the standpoint of corporate finance that all seemed fine. But it also bothered me and meant that a lot of real estate investing made no economic sense. I wasn't actively looking for the answer to my discomfort (I had other things to think about), but I happened upon it quite by accident while reviewing an offering memorandum for a stabilized multifamily asset in New York City's Gramercy Park area.
Growth and Reinvestment
One of the fundamental principles of corporate finance is that growth, by itself, does not create value. This is taught, sometimes with religious fervor, in any introduction to corporate finance or valuation course. A company creates value when the return it earns on incremental invested capital exceeds its cost of capital. If ROIC equals or is less than WACC, the company can grow, but the growth adds scale rather than economic value.
The even more fundamental point, which often goes unstated because it seems so obvious, is that corporate growth almost always requires investment. If you want to produce more widgets or a new generation of widgets you build more factories or invest in more modern manufacturing equipment. You can't grow into new markets without significant investment in plant, equipment, logistics and transportation. Whether you are expanding through manufacturing facilities, warehouses, stores or data centers, all of that requires significant capital expenditures.
The current wave of investment in artificial intelligence provides perhaps the largest real-time example of this principle. Semiconductor fabrication plants, hyperscale data centers, electrical infrastructure, networking equipment and software development will require hundreds of billions of dollars of capital. Those investments will undoubtedly produce growth. The question investors are asking is not whether growth will occur. The question is whether the return on that extraordinary investment will exceed the cost of that capital. That is the corporate finance question in its purest form.
But then I started thinking long and hard about the investment property in Gramercy Park. Going-in cap rate (pro forma) of 6.3%. Assumed cost of debt 5.75% interest, 30-year amortization. Leverage 68%. Cash-on-cash return a paltry 4.75%. But if I simply calculate a seven year hold period with both rents and expenses growing at 3% per year and an exit cap rate unchanged, I am now modeling a pre-tax return of approximately 9.3% and a leveraged pre-tax return of approximately 15%. The return above the going-in yield comes from somewhere, and the explanation is the growth in revenue (i.e. rents) without proportional incremental investment. Nothing changes physically about the productive capacity of the asset. No apartments are added; there has been no major renovation or repositioning. The owner makes the expenditures necessary to maintain the building, but otherwise the asset is essentially unchanged.
Growth Without Reinvestment
This is a fundamental point worth dwelling on. Market rents increase by 3%. But this happens without incremental investment designed to produce that growth. And the algebra makes this even stranger and more counterintuitive. If rents and operating expenses both grow at 3%, NOI will also increase by 3%. You may have to work your own simple example to accept this, but if revenue and expenses both grow by the same percentage, their difference — NOI — grows by that percentage as well.
Economically something interesting has happened. The owner now has an asset generating 3% more NOI without having made a proportionate incremental investment to produce it. That is quite different from a corporation building another factory or a distribution center or investing in equipment designed to produce more technologically advanced computer chips.
And in a supply-constrained real estate market, the effect can be even more pronounced. If rents increase 4% while expenses increase only 3%, NOI will grow by more than 4%, because revenue is larger than expenses. You can do the math. The property's operating margin expands. Again, that growth may require little incremental investment. It can arise simply because tenants are willing to pay more for the right to occupy a scarce location. That isn't a return on incremental invested capital. It is an increasing economic rent accruing to the owner of an existing scarce asset.
None of this contradicts the central insight of corporate finance. If growth requires incremental investment, the return on that investment must exceed the cost of capital before value is created. My point is simply that certain forms of stabilized real estate growth arise from increasing economic rents on an already-existing scarce asset, not from incremental capital expenditures.
Back to the Cap Rate
Now reconsider our property in Gramercy Park purchased at a 6.3% cap rate. If NOI never grows and the property is eventually sold at the same 6.3% cap rate, the economics are straightforward. Ignoring transaction costs and other complications, the unlevered return is approximately 6.3%. But suppose NOI grows 3% annually without requiring significant incremental investment and the property is sold seven years later at the same 6.3% cap rate.
The economics are now very different. The investor receives the 6% current yield plus the benefit of the growing NOI. Because the exit cap rate remains unchanged, the property's value grows along with its NOI. As we have seen above: 6.3% cap rate + 3% NOI growth = 9.3% unlevered return. Clearly, the 3% deserves more careful consideration than simply treating it as irrelevant.
An Important Qualification
None of this means that real estate growth is free. Buildings consume capital. Roofs leak. Boilers fail. Elevators need replacing. Apartments require renovation. Leasing costs money. This highlights another important distinction: NOI is not free cash flow. NOI is calculated before capital expenditures (and leasing commissions). So, the proper economic analysis must deduct the recurring capital expenditures (in excess of annual repairs and maintenance) necessary to maintain the property's income-producing capability — perhaps through modeling a capex reserve.
Nor does all real estate growth fall into the category I am describing. If an owner spends $10 million repositioning a building in order to increase rents, we are right back in the traditional corporate-finance framework. The relevant question is whether the incremental return on that $10 million exceeds the required return. But growth in market rents on an already-existing, stabilized asset is different. There may be very little incremental capital associated with that growth.
Why This Matters
For years I have disliked the phrase "the property appreciated in value." It describes what happened without explaining why. A property can become more valuable because investors accept a lower cap rate. That's multiple expansion. If you want to model that, you need to justify it. It can become more valuable because the owner invested additional capital and increased its earning power. If so, what was the incremental return created by that investment? Or it can become more valuable because the cash-generating ability of an existing scarce asset increased without requiring proportionate additional investment.
Those are three very different economic stories. And that is where corporate finance and real estate finance can diverge in an interesting way. The corporate-finance principle remains correct: growth creates value only when the return on the capital required to generate that growth exceeds the cost of that capital. But there is an important corollary: sometimes growth doesn't require much additional capital.
For an owner of stabilized real estate in a supply-constrained market, that distinction can matter enormously. It took me some time to put all of this together. I think I was trying to force the economics of a scarce real estate asset into a corporate-finance framework in which growth is almost always purchased with additional capital. In hindsight my mistake seems obvious. I will try to take some comfort from the expression "better late than never."