Return on cost and value per dollar for an apartment interior programme, with the downtime and vacancy the quick version leaves out.
Divide the annual rent premium, after vacancy, by the all-in cost of the renovation including the rent lost while the unit is empty, then capitalise the premium at the exit cap rate to see the value created. A 14,000 renovation that adds 175 a month, with a month of downtime, returns 12.91 per cent on its 15,450 all-in cost and creates 36,273 of value per unit at a 5.50 per cent cap, 2.35 times what it cost. Below a premium of 74.5 a month it creates no value at all.
Worked in full in Private Equity Real Estate by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Interior renovation is the core move of most value-add apartment strategies: buy a building with dated units, refit them as they turn over, and lease them at a premium. The question an investment committee asks is not whether the units will look better but whether each dollar spent comes back as more than a dollar of value. That is two numbers, return on cost and value per dollar, and both depend on lines that the quick version leaves out.
| Input | Value |
|---|---|
| Units renovated | 120 |
| Hard and soft cost per unit | 14,000 |
| Current rent per unit per month | 1,450 |
| Rent premium after renovation, per month | 175 |
| Downtime per unit, months of lost rent | 1 |
| Vacancy and credit loss applied to the premium | 5% |
| Exit cap rate | 5.50% |
The premium is the one figure everything rests on, and it should come from leased comparables of renovated units nearby, not from the asking rents of the first few units the sponsor refits itself. At 175 on 1,450 it is a 12.1 per cent uplift.
All-in cost = renovation cost + current rent × months of downtime
Net annual premium = monthly premium × 12 × (1 − vacancy)
Return on cost = net annual premium ÷ all-in cost
Value created = net annual premium ÷ exit cap rate
In Excel: =Prem*12*(1-Vac)/(Cost+Rent*Down) for the return on cost and =Prem*12*(1-Vac)/Cap for the value.
Across the programme, 120 units cost 1,680,000 in works and 1,854,000 all-in, add 239,400 a year of net income and create 4,352,727 of value: 2,498,727 more than they cost.
The test that matters is the spread between return on cost and the exit cap rate. A renovation earning exactly the cap rate creates value equal to its cost and nothing more; the sponsor would have done as well buying the extra income in the market. That break-even sits at a premium of 74.5 a month on these costs. At 175, the return on cost is 12.91 per cent against a 5.50 per cent cap, a spread of more than 7 points, which is why value-add interiors are popular when the premium holds.
Set a hurdle above the cap rate, not at it. The cap-rate break-even ignores execution risk, the time the programme takes and the cost of the capital tied up while units are empty. A return on cost 150 basis points over the cap, 7.00 per cent, needs a premium of about 95 a month; 300 basis points over, 8.50 per cent, needs about 115.
| Premium per month | Cost 10,000 | Cost 14,000 | Cost 18,000 | Cost 22,000 |
|---|---|---|---|---|
| 125 | 12.45% | 9.22% | 7.33% | 6.08% |
| 150 | 14.93% | 11.07% | 8.79% | 7.29% |
| 175 | 17.42% | 12.91% | 10.26% | 8.51% |
| 200 | 19.91% | 14.76% | 11.72% | 9.72% |
| Exit cap | Value created | Profit over all-in cost | Multiple |
|---|---|---|---|
| 5.00% | 39,900 | 24,450 | 2.58x |
| 5.50% | 36,273 | 20,823 | 2.35x |
| 6.00% | 33,250 | 17,800 | 2.15x |
| 6.50% | 30,692 | 15,242 | 1.99x |
The grid shows where programmes fail. A heavier scope at 22,000 with only 125 of premium returns 6.08 per cent, barely above the cap: the sponsor has spent a great deal of money to stand still. Exit cap moves matter less here than in the asset as a whole, because they apply only to the premium, but a 100 basis point rise still takes 5,580 of value out of every unit. Downtime matters too: three months empty instead of one raises the all-in cost to 18,350 and cuts the return on cost to 10.87 per cent.
The quick version divides the gross premium by the works cost: 2,100 ÷ 14,000 = 15.00 per cent, and capitalises the gross premium to 38,182 per unit. It leaves out the rent lost during the works and the vacancy on the new rent. On this programme that overstates the profit by 3,359 per unit, 403,091 across 120 units, before anything has gone wrong. The second mistake is to value the premium at the going-in cap rate of the whole building when renovated units will be bought at a cap rate that reflects their higher rent and the next owner's capex.
The same spread logic applies to ground-up schemes as yield on cost against the market cap rate; and whether the exit cap itself is right is the question in what makes a cap rate good.
Measure a renovation on its all-in cost and its net premium: 12.91 per cent here, against a 5.50 per cent cap, creating 2.35 dollars of value per dollar spent. Then find the premium at which it stops working, 74.5 a month, and ask how confident the comparables make you that the real premium sits well above it. The free workbooks for this book take value-add returns net of fees and promote, which is the next question once the asset-level spread is known.
One comfortably above the exit cap rate, because a renovation earning exactly the cap rate only creates value equal to its cost. With a 5.50 per cent cap, a hurdle 150 basis points higher means 7.00 per cent, needing a premium of about 95 a month on a 15,450 all-in cost. The worked programme earns 12.91 per cent, a spread of more than 7 points.
Capitalise the annual premium net of vacancy at the exit cap rate. A 175 monthly premium is 2,100 a year, 1,995 after 5 per cent vacancy; at a 5.50 per cent cap that is 36,273 of value per unit. Subtract the all-in cost of 15,450 to get 20,823 of profit, or a 2.35x value multiple.
Yes. A unit taken offline for a month to be refitted loses its current rent, and that is as much a cost of the programme as the works. At 1,450 a month it lifts the all-in cost from 14,000 to 15,450. With three months of downtime the all-in cost is 18,350 and the return on cost falls from 12.91 to 10.87 per cent.
Chapter 5 of Private Equity Real Estate places value-add within the four-tier risk-return spectrum, and the free companion workbooks take each tier's return net of fees. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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