Why Investors Require Returns
Equity is the money that loses first, so it is the money that must be paid the most, and it will leave if it is not.
The last lesson ended with the lender paid. This one is about the other money: the equity that owners and their investors put in, which in our illustration is $8,400,000 of a $24,000,000 building. By the end you should understand why that money is not free, how its price is measured, and why the price shows up in rent as surely as the mortgage does.
We will not argue that the price is fair or unfair. Our job is to make it visible, so readers can judge for themselves once they see what the return is and what it competes against.
Equity loses first
Recall the order in which a building's income is spent. Operating expenses come first. Then the lender is paid, in full, whether or not the building is doing well. Whatever remains belongs to the equity. If rents come in lower than planned, or costs come in higher, the lender still receives its $1,183,231 and the shortfall lands entirely on the owners.
The same holds during construction: overruns, a delayed opening, or a slow lease-up consume the owners' money before anyone else's. If the project fails altogether, the lender takes the building and the equity is gone. Equity is, by design, the layer that absorbs losses first.
That ordering is why equity requires a higher return than debt. A lender at 6.5% is being paid to accept a small risk with a senior claim. An equity investor is being paid to accept a large risk with the last claim.
Capital has other places to go
The money that funds a building is not committed to housing by nature. Before it becomes equity in an apartment project it sits in a pension fund, an insurer, a family's savings, or a developer's balance sheet, and each of those holders can put it somewhere else: into government bonds at almost no risk, into shares, or into an existing building that is already leased.
Each of those alternatives offers a return. The return on the safest of them, roughly the yield on government debt, is the floor. Everything riskier has to offer that floor plus a risk premium: extra return in exchange for the chance of loss. Building a new apartment complex is among the riskier uses on the list, because it takes years, involves construction, and produces no income until it is done. So its required return sits well above the floor.
The required return is therefore not a number a developer chooses. It is set by the market for capital, and when safe yields rise, every other required return rises with them, including the one needed to build housing.
Three ways of measuring the return
Investors describe what they require in a few overlapping ways. The definitions are simpler than the vocabulary.
- Cash-on-cash return is the cash left after debt service each year, divided by the cash invested. If the illustrative building produces $667,769 after paying the lender, on $8,400,000 of equity, the cash-on-cash return is 7.95%. This is the measure our rent math uses, with an 8% target.
- Preferred return is a promise inside a partnership: outside investors receive a stated return, say 8% a year, before the developer shares in any profit. It ranks the developer behind its own investors and gives them first call on the cash.
- Internal rate of return (IRR) measures the return over the whole life of an investment, from the first dollar in to the last dollar out, including the eventual sale. It accounts for timing: a dollar returned next year is worth more than the same dollar returned in ten.
What the return costs in rent
Added to $1,183,231 of debt service, the building must produce $1,855,231 of net operating income before its owners see the return they require.
Holding the building, the loan, and the operating costs fixed and changing only the return the equity requires gives the following.
| Required equity yield | Annual equity return | Required NOI | Required rent per unit per month |
|---|---|---|---|
| 6% | $504,000 | $1,687,231 | $2,006 |
| 8% | $672,000 | $1,855,231 | $2,154 |
| 10% | $840,000 | $2,023,231 | $2,301 |
Two points of required yield move rent by roughly $150 per unit per month. That is a real amount, and it is why the cost of capital belongs in any honest conversation about affordability. It is also smaller than the effect of construction cost itself: under the same assumptions, a $40,000 change in cost per unit moves rent by about $270 (from $2,154 at $240,000 per unit to $2,425 at $280,000).
Developer fee is not the same as profit
Readers often hear "developer profit" as a single thing. In practice it is two different lines. The developer fee is a payment, usually a few percent of project cost, for the years of work it takes to find a site, secure approvals, arrange financing, and manage construction. It is listed in the soft costs and is often partly deferred until the building succeeds. It is compensation for labor, closer to a salary than to a windfall.
Profit, by contrast, is what the equity earns beyond its required return. If the building performs exactly as planned, the equity receives its 8% and no more. Profit above that comes from doing better than the plan: leasing faster, building for less, or selling when values are higher. It can also be negative. The pro forma shows the required return because that is the amount the building has to deliver; it does not show a guaranteed profit because there is not one.
The return on equity is one line in a larger picture. In the illustration it is $672,000 of the $2,584,454 the building must collect each year, about a quarter; the rest is debt service, operating costs, and the vacancy allowance. Removing the return entirely would lower the required rent but would not bring it close to what many households can pay, and it would mean nobody supplied the equity. The launch article Developer Profit and Affordability works through that arithmetic line by line.
When the return is not there
The most important thing to understand about required returns is what happens when they are not met. Nothing dramatic occurs. The investor who would have funded the building simply looks at the numbers, sees that the expected return is below what a warehouse or a bond or an existing building offers at comparable risk, and puts the money there instead.
Construction is the residual. It happens when the required rent from Lesson 4 is at or below what the market will pay, and it stops when it is not. A rule that raises cost, a rate increase that raises debt service, or a rent limit that lowers income does not reduce the required return; it reduces the number of projects that can meet it. The buildings that are not started leave no trace, which is why this mechanism is easy to overlook.
Illustrative 100-unit building: total development cost $24,000,000; permanent loan $15,600,000 at 6.5% over 30 years (annual debt service $1,183,231); equity $8,400,000.
Required cash-on-cash return on equity 8% per year, which is the publication's default; the table varies it to 6% and 10% with everything else fixed.
Operating expenses $600,000 per year; vacancy and credit loss 5%. Required rent = (debt service + equity return + operating expenses) ÷ 0.95 ÷ 100 units ÷ 12.
The $667,769 cash flow after debt and 7.95% cash-on-cash figure come from the illustrative pro forma at $2,150 rent used throughout this series.
The cost sensitivity ($2,425 at $280,000 per unit) applies the same formula to a $28,000,000 total development cost.
No figure here describes actual market returns. The hurdles and splits are structures chosen to show why the required number sits where it does, modeled from the assumptions above rather than drawn from any survey of investors; a real partnership's terms are set out in its own agreement.
A fall in safe interest rates would lower the return equity requires, and with it the required rent, because the alternative uses of capital would pay less.
A subsidy that reduces the equity needed, or that accepts a below-market return on part of it, would lower the required rent by the amount of return it replaces.
A rent limit that lowered expected income without lowering cost would leave the required return unchanged and the project unbuilt.
Costs, loans, and returns each have a claim on the rent. The next lesson looks at the actor that touches nearly every one of those lines at once. Next lesson: Lesson 7: How Government Affects Housing Economics.
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