Case 054Real estate and infrastructureCore

A fund builds a logistics park on land it buys. What is the yield on cost once it is leased, and what is the development profit if it sells at a 7.5% cap rate?

Carlyle GroupWashington DC · 2021

The situation

Bhandar Logistics Parks wants to build a warehouse park outside a port city. Land costs Rs 80 crore and construction Rs 220 crore, giving 12 lakh sq ft of leasable space. Market rent for grade A warehousing is Rs 25 per sq ft a month and the park is expected to be 90% leased once stabilised. Operating cost is 10% of rent collected.

Stabilised, income-producing warehouse parks sell at a 7.5% cap rate. Ignore the time to build and lease, financing cost during construction and transaction costs for the first pass; the interviewer will add them later.

Your task

What is the stabilised NOI and the yield on cost, what is the park worth at a 7.5% exit cap rate, and what is the development profit and margin?

Quick check

Before working it: where does a developer's profit actually come from?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Stabilised NOI is Rs 29.2 crore, a 9.7% yield on Rs 300 crore of cost, and at a 7.5% cap rate the park is worth about Rs 389 crore, a development profit of about Rs 89 crore, 30% of cost. Gross rent at full occupancy is Rs 36 crore; 90% leased collects Rs 32.4 crore; 10% opex leaves Rs 29.2 crore. The profit is the spread between building at 9.7% and selling at 7.5%, and it disappears if either the cost or the cap rate moves against you.

Step 1What does the finished park earn, and what did it cost to create?

Rent first, cost second. Think of someone who builds a row of shops for Rs 3 crore and lets them for Rs 29 lakh a year: they are earning almost 10% on what they spent, and the question is what a buyer would pay for that income. 12 lakh sq ft at Rs 25 a month is Rs 36 crore of gross rent; 90% leased collects Rs 32.4 crore; after 10% operating cost, NOI is Rs 29.2 crore on Rs 300 crore of land and construction. That ratio, 9.7%, is the yield on costStabilised net operating income divided by the total cost to build and lease the property. The return the developer earns before any sale..

Step 2Where does the development profit come from?

From selling a 9.7% yield to a buyer who accepts 7.5%. At a 7.5% cap rate the Rs 29.2 crore of NOI is worth Rs 389 crore, Rs 89 crore more than it cost to create, a 30% margin on cost. The buyer pays a lower yield because the risk is gone: the land is bought, the building stands and the tenants are signed. The developer earned the 2.22 point spread by carrying those risks. Say that sentence in the interview; it is the whole logic of development.

Bhandar spends Rs 80 crore on land and Rs 220 crore on construction to create Rs 29.2 crore of NOI, a 9.7% yield on cost; a buyer at a 7.5% cap rate values the same NOI at Rs 389 crore, so the spread between the two yields is a development profit of Rs 89 crore, 30% of cost.

The relationship

\text{Yield on cost} = \frac{29.2}{300} = 9.7\% \qquad \text{Value} = \frac{29.2}{0.075} \approx 389

29.2	stabilised NOI: rent on 90% of 12 lakh sq ft at Rs 25, less 10% operating cost
300	land plus construction cost
0.075	the cap rate a buyer of a finished park accepts

What it says in wordsThe developer earns the stabilised income divided by what it spent, and sells to a buyer who values that same income at a lower yield, which means a higher price.

Step 3How fragile is the Rs 89 crore?

Move one input at a time, because the profit is a spread and spreads are thin. If buyers want 8.5% instead of 7.5% at exit, value falls to Rs 343 crore and profit to Rs 43 crore; a 10% construction overrun cuts profit to Rs 67 crore; rent of Rs 22 instead of Rs 25 cuts it to Rs 42 crore. A one-point move in the exit cap rate costs as much as a 10% overrun on the whole build, which is why developers watch the yield market harder than the contractor.

Case	Cost	NOI	Yield on cost	Exit cap	Value	Profit
Base	300	29.2	9.7%	7.5%	389	89
Exit cap 8.5%	300	29.2	9.7%	8.5%	343	43
Build cost +10%	322	29.2	9.1%	7.5%	389	67
Rent Rs 22	300	25.7	8.6%	7.5%	342	42

Rs crore. The base case earns Rs 89 crore; a one-point wider exit cap rate, a 10% construction overrun or rent Rs 3 lower each remove a third to a half of it, because the profit is the gap between a 9.7% yield on cost and a 7.5% exit yield.

Step 4What did the first pass leave out, and which omission matters most?

Time. The Rs 300 crore is spent over two years of construction and a year of leasing before the Rs 29.2 crore arrives, so the true cost includes interest on a construction loan and the equity's own time, and the profit must be judged as an IRR over roughly three years, not as a margin. Transaction costs on the sale, a leasing commission, and the risk that 90% occupancy takes longer than planned all sit on the same side. A 30% margin over three years is a respectable development return; the same margin over five would not be.

Where candidates lose it

The usual loss is applying the cap rate to gross rent: Rs 36 crore over 7.5% gives Rs 480 crore and a profit that does not exist. Cap rates apply to NOI after vacancy and operating cost, Rs 29.2 crore.

The second miss is calling the 9.7% yield on cost the return. The return is the profit on exit, which depends on the cap rate a buyer accepts, and a developer who cannot sell at 7.5% has a 9.7% income asset, not a 30% profit.

What the interviewer asks next

Construction takes two years and is funded 60% by a loan at 10%. What does that do to cost and profit?
The anchor tenant wants a 15% discount for taking half the park. Do you accept?
At what exit cap rate is there no development profit at all?
Why do infrastructure funds buy stabilised parks at 7.5% rather than develop at 9.7%?

Asked at Carlyle Group, Real Estate, Washington DC, 2021 (Wall Street Oasis): followed by a 2-hour modeling test and an 8 interview super day

Company names and figures are illustrative.