How to underwrite build-to-rent: the pro forma and yield on cost, line by line

The short answer

Yield on cost is a stabilized year's net operating income divided by the all-in cost to build. For 120 homes renting at $2,400 a month and costing $285,000 each, with the operating costs below, NOI is $18,344 a home and the yield on cost is 6.44%. Against a 5.25% exit cap rate that's a spread of 119 basis points, and the community is worth about $7.7 million more than it cost.

The pro forma, line by line

A build-to-rent pro forma has two halves: what a stabilized year brings in and costs to run, and what it costs to build. Here's the example, per home and for the community.

Operating costs come to $9,574 a home, 34% of collected income. That's the line most first-time BTR budgets get wrong, mostly on property tax and insurance.

Yield on cost and cap rate

Both are NOI divided by a number. Yield on cost divides it by what the homes cost you to build. The cap rate divides it by what a buyer would pay for them once they're leased. Same income, two denominators.

So the comparison tells you whether building creates value. In the example, $18,344 of NOI at a 5.25% cap rate is worth $349,405 a home. It cost $285,000 to build, so each home is worth $64,405 more than it cost, a 22.6% profit on cost. If the yield on cost were below the cap rate, the community would be worth less than it cost, and buying an existing one would beat building it.

One trap with the term: yield on cost also means a stock's dividend over its purchase price. Pages about dividends use the same words for something else entirely.

The development spread, and how much is enough

The spread is yield on cost minus the cap rate. In the example it's 6.44% less 5.25%, or 119 basis points. It's what pays for the risks a buyer of a finished community doesn't take: construction costs that run over, a slow lease-up, rents that come in lower, and a cap rate that moves while you build.

Developers commonly look for somewhere around 100 to 200 basis points, more on riskier deals and in markets where cap rates are moving. A thin spread can still work for a builder who sells the homes to an operator in bulk at a set price, because that takes the exit risk off the table.

How to underwrite a build-to-rent deal, step by step

1. Set the rent

Use effective rent, after concessions, for each plan you'll build, and blend them by the mix. Rents from existing single-family rentals nearby are a guide, though new homes in a managed community often rent above older homes scattered through a neighborhood.

2. Add other income and take out vacancy

Pet rent, parking, storage and smart-home fees are real but small. Vacancy and credit loss together usually run several percent of gross income in a stabilized year, more while you lease up.

3. Take out the operating costs

Property tax on the finished, reassessed homes, insurance, repairs and turnover, the HOA and common areas, capital reserves, other costs such as common-area utilities and marketing, and management as a share of collected income. Price each one per home per year.

4. Add up the all-in cost

Land, vertical construction, site work, and soft costs and financing, per home. Include the interest during construction and lease-up, and the amenities a rental community needs that a for-sale one might not.

5. Work out the yield on cost

Divide the NOI by the all-in cost. In the example, $18,344 ÷ $285,000 = 6.44%.

6. Value it at the exit cap rate

Divide the NOI by the cap rate a buyer would pay for a leased-up community like yours, and compare the value with the cost.

7. Check the spread, then solve for the land

If the spread is too thin, work back from the yield you need to the land price that gets you there. That's the next section.

Working back to a land price

Turn the yield on cost around and you get the most the community can cost: NOI divided by the target yield. Take out everything but the land and what's left is the most the land can cost.

Most it can cost = NOI ÷ target yield on cost
Land             = most it can cost − vertical − site work − soft costs

At a 6.75% target, $18,344 of NOI supports $271,759 of cost a home. Less $185,000 to build, $30,000 of site work and $25,000 of soft costs, that leaves $31,759 a home for the land, $13,241 under the $45,000 in the budget. That's the same residual idea builders use for for-sale homes, run on rent instead of a sale price. The land basis guide walks through the for-sale version.

What moves the yield

Rent and cost move the yield on cost. The cap rate doesn't move the yield at all, but it moves the value and the profit more than anything else.

The property tax line is the one to look at twice. Tax on the land under a rental community says almost nothing about tax on the finished homes, and the way states assess rental homes differs a lot. The state section on the calculator page covers Georgia, the Carolinas, Alabama and Tennessee.

Lease-up and timing

The pro forma above is a stabilized year. Before you get there, homes deliver in phases, lease over months, and often go out with a free month or two. During that time you carry the construction loan on homes that aren't yet earning full rent.

Put that cost in the budget as part of soft costs and financing: the interest on the loan through lease-up, the concessions, and the operating costs of homes that sit empty. That's where a slow lease-up shows up; the stabilized yield barely moves.

Build to rent or build to sell?

For a builder with a site, the choice comes down to which exit supports more for the land and carries less risk. A for-sale community earns a margin on each closing and is done when the last home sells. A rental community earns the spread when it's sold or refinanced, and it ties up capital until then. Some builders split the difference by selling a finished, leased community or a block of homes to a rental operator at a set price.

Running both residuals on the same site shows which exit the land supports: the residual land value calculator for the for-sale case and the build-to-rent calculator for the rental case.

Terms

Build-to-rent (BTR)

A community of homes built to be rented, usually owned and managed as one property.

Pro forma

A projection of a deal's income, costs and returns. For BTR, usually one stabilized year plus the cost to build.

Stabilized year

A year of operations after lease-up, at normal occupancy, with concessions burned off.

Effective rent

Rent after concessions such as free months.

Net operating income (NOI)

Collected income less operating costs, before debt payments and income tax.

Yield on cost

NOI divided by the all-in cost to build. Also called return on cost or development yield.

Cap rate

NOI divided by the price a buyer pays for the leased-up property.

Development spread

Yield on cost minus the exit cap rate, in basis points.

Profit on cost

Value when finished, less the cost to build, divided by the cost.

Bulk sale

A builder selling a group of finished homes, or a whole community, to a rental operator at once.