Why we focus on unlevered yield

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Had someone write in and ask me why we focus on unlevered yield when we look at deals.

To be clear, unlevered yield is calculated by dividing the forecast annual net operating income from a property by the cost total cost of buying and renovating it… in other words, treating the project like it will be done all-cash, with no debt.

It’s a good question, because a lot of other people in the business look at levered yields (in other words, they assume there will be a mortgage on the property).

We have two main reasons for ignoring debt when we’re under-writing a project:

  1. Using lots of leverage can make a so-so project look ok or even great, particularly if you forecast rent growth in the future and/or an exit (sale) at an aggressive cap rate. We don’t forecast rent growth, we don’t forecast exits, and we don’t want to do so-so deals.
  2. Using leverage to make your deal work puts you at the mercy of the debt markets, and we try to avoid putting ourselves and our investors at the mercy of forces we can not control.

To expand on point 2 above: When we completed the repositioning of our first batch of deals via our old company, Better Dwellings, in 2011-12, we knew that we have created a TON of value. We thought for sure that we would be able to get banks to underwrite our stabilized rent rolls and then cash us out on refinances with cheap debt.

They refused. Banks were extremely gun-shy after the crash, and, despite all of the numbers showing that the buildings could easily handle the leverage, they simply refused to make the loans.

This had a HUGE impact on my thinking. Once you see that banks can/will behave irrationally, you realize that you don’t want to base your business model on them behaving rationally.

How do you avoid leaning on the banks? Well, you make sure that you do deals where the unlevered yield is sufficiently high that you and your investors would be ok with just holding the deals all cash. That way, if the banks want to loan on terms that make sense, great. If not, you’re still ok.

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