Four Numbers, Four Lenses
No single number tells the truth about a deal. Here are the four we screen every one through — and the blind spot each one guards.
I titled this newsletter “Worth Building” because deciding what is worth building is the bulk of my job. Most, not all, of our projects are funded by private capital. From the private-capital lens, worth isn’t a feeling or a story; it’s based in math — investment return. But no single number captures return, which is the problem. Here are four metrics we use to screen our deals, and each one shows you an angle the others miss. None of them will insulate you from a Black Swan event. Ask anyone who owned a West Coast downtown office tower (or any downtown asset class for that matter) in 2020: no development forecast had a pandemic hollowing it out. What these four can do is measure how much room you have to navigate adverse unknowns — often the difference between crossing the chasm of a down market and not reaching the other side.
Which of the four the market cares about most changes with the capital markets. When money is cheap and growth is assumed, everyone underwrites to the exit and the numbers that reward the dream get the attention. When money is expensive and the future looks uncertain, the market focuses on immediate income and maximum margin. The metric of the moment follows the real estate and capital market cycles. The discipline is to screen all four regardless — because each one guards a different blind spot. We’re wired to build a confident story from the number in front of us; the other three are heuristics that warn against blind spots.
Underneath all four is a single distinction that is critical, particularly for value-add or development projects: trended versus untrended. A trended number grows today’s rents into the future — and sometimes assumes the market will pay a higher price for the same income years out. An untrended number uses today’s rents and today’s prices. That distinction is how you band a deal. More importantly, it distinguishes the real value added of new-construction or value-add projects (more on this below). It’s too easy to feel like a genius when the market is going your way — thinking that the value from your new projects comes from your cunning, rather than simply a rising tide.
Yield on cost is the truth teller. It’s the income the building will throw off once it’s stabilized, divided by what it costs you to build or buy it — real estate’s version of the earnings yield on a stock. Read it untrended, on today’s rents, and it’s the hardest number in the model to argue with. It also ignores the cost of debt, which is exactly why it’s useful. It’s simple and valuable.
Development margin is the moat. It’s the spread between what an asset costs to create and what it’s worth finished, and it’s the investors’ payoff for taking development risk — entitlements, construction, and two years between groundbreaking and the lease-up. It’s also the number most dependent on a cap rate you’re projecting years out (the cap rate is what the market uses to turn a building’s income into a price; a lower one means a higher value), and cap rates are an exogenous market variable, not yours to control. So the honest test strips the projection out: value the finished building at today’s rents and today’s cap rates, against today’s cost. If the margin holds untrended, the moat attributable to development is real. If it only appears with the assumption of compressed cap rates, the moat isn’t the developer’s contribution — it’s market speculation. If you can buy an equivalent building standing for the same money, you’re paying to take construction risk for something you can buy finished. Never pay more to build what you could have bought.
The first two are defensive — they tell you whether a deal is sound. The next two tell you whether you will earn enough to make the investment worthwhile. How you weight each one depends on your investment objectives — including tax sensitivity and time-horizon.
Cash-on-cash is the paycheck. It’s the cash that spins off the investment, divided by the equity you put in. It ignores time-value of money discounts, but provides for actual checks to the bank. This lens comes back into fashion whenever money gets expensive and income gets scarce, and gets a back seat when the market is strong, when capital gain is easier to come by. It’s also the most sensitive to how the deal is financed: leverage and rate structure can dominate it over real estate strategy. It’s the number that matters most to investors living on their dividends — seeking modest but durable returns, not a big figure at the end. And as we’ll see with IRR, it’s also deceptive: a healthy cash-on-cash can be manufactured with leverage that quietly loads the deal with risk.
IRR is the opportunity — and the siren. Internal rate of return is the compounded annual return over the life of the deal. Where the cash-on-cash investor wants to live off the deal, the IRR-focused investor wants to maximize the compound growth rate of their capital over the hold period. It’s one of the truest figures in terms of gauging return, but also the easiest number in the model to inflate. Add debt and the IRR climbs — and so does the risk. A high IRR can mean you found a great deal or that you took a great deal of risk, and the IRR alone won’t tell you which. I read it last, after the untrended numbers have shown whether the deal has enough protective moat to stand market volatility.
This is where Daniel Kahneman’s WYSIATI comes in — what you see is all there is, the trap of judging a deal by a single number in front of you. Humans are bad at pricing risk, so we lean on heuristics; yield on cost is one, because it compares opportunities before leverage amplifies both the returns and the risk.
None of the four is the answer. Each is a lens, and each has a blind spot. Yield on cost tells you whether the building itself, without financing distortions, earns its keep but misses return on equity; cash-on-cash tells you whether you’re paid during the hold but ignores the exit; IRR captures the whole life of the deal but hides how much risk bought that return; the margin tells you whether the building is worth developing at all. Worth, from the capital lens, isn’t any one of them clearing. It’s all four (or at least three, based on your objectives) agreeing — on today’s numbers.
If a deal earns its yield on today’s rents, holds its margin without cap-rate help, provides cashflow while we hold or clears on IRR without leaning too heavily on debt, it’s worth building. If it only works with cap-rate compression and upward-trending rents, better we learn at our desk than on our bank statements.
Worth reading
The Most Important Thing, Howard Marks — clear writing on risk, emphasizing what you can’t see in the return, but what you assumed to get there.
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