Leveraged Breakdowns

REPE Interview Prep: What are the main REPE strategies? Explain NOI and Cap Rates

Leveraged Breakdowns exists to prepare you for a career in real estate private equity. To that end, this series covers interview questions you’ll likely face when searching for real estate private equity jobs. Make sure you check out our courses, Breaking Down REPE and the REPE Starter Kit, to get the hard technical skills you need to excel in any case study.

Question 1: What are the main strategies that real estate private equity firms use to invest in real estate?

Bullet answer: main strategies are core, core-plus, value-add, and opportunistic. Asset quality follows that order, target returns are inverse (opportunistic highest returns, lowest asset quality).

The main investment strategies are Core, Core-Plus, Value-Add, and Opportunistic. Asset quality and cash flow predictability follow that order from best to worst, and target returns are the inverse: lowest to highest.

Core funds seek the best properties in the largest and most attractive markets, have little to no deferred maintenance, low leverage, and maintain high occupancy with credit tenants. These components result in a very low risk profile, so the returns are also the lowest, often in the seven to nine percent range.

Core-Plus begins to take on some additional risk in order to boost returns into the eight to eleven percent rage. This added risk usually comes from slightly inferior markets, tenant credit quality, shorter remaining lease terms, and slightly higher leverage.

Value-Add funds generally target returns in the mid-teens, seeking properties in much smaller markets with higher vacancies, and deferred maintenance. Part of the equation in boosting returns is higher leverage.

Finally, Opportunistic generates the highest returns, usually 20% or better. Most ground-up development and major redevelopment projects fall into this category. Interestingly, as the economic cycle matures, funds often buy further down the risk curve because of competition for limited buying opportunities, and with lower return thresholds, they can afford to pay more.

Eager to learn more? Check out our earlier article, Investment Strategies in the REPE Universe.

Question 2: talk to me about NOI and cap rates.

Bullet answer: NOI is pure property cash flow (think EBITDA, but with maintenance reserves). Cap rates are an inverse multiple applied to NOI. Value = NOI / cap rate (lower cap rate, higher value).

NOI is the pure cash flow that a property generates, regardless of capital structure and costs. It’s a similar concept to EBITDA. The only exception is that in real estate, most underwriting of NOI includes maintenance reserves, which is technically a capital item. NOI is one of the two key drivers of value in real estate, the other being the cap rate.

In its simplest terms, the cap rate is the unlevered rate of return for an investment property. The formula that drives all real estate activity is: NOI divided by cap rate equals market value. If you know any two variables, you can solve for the third. Cap rates are inversely related to value, so a lower cap rate means higher value, just like bonds. Cap rates are one of the common units of measurement for comparing one investment to another, like rent per square foot or cost per square foot.

Why include maintenance reserves within NOI? The reason that maintenance reserves are usually built into the NOI analysis is that the core asset, regardless of how you capitalize or how you depreciate the deal, requires regular replacement in order to maintain its functionality. This cost is, therefore, logically included in the net operating income that it generates.

Dive deeper with our earlier articles, Beginner’s Guide to Commercial Leases Part 1 and Part 2, and Cap rates – Textbook vs. Street to further prepare for your career in real estate private equity. And remember, real estate private equity jobs are competitive, so make sure you are always pushing to stay sharp.

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