Cap rate is a blunt instrument—useful for a quick vibe check, dangerous as a decision rule. Sophisticated limited partners (LPs) dig deeper, focusing on metrics that connect business plan, leverage, timing, and downside control. Here are six advanced lenses to evaluate opportunities with rigor.
1) Equity Multiple (and Duration-Aware IRR)
What it shows: Total cash returned per dollar invested, including interim distributions and sale proceeds.
Why it matters: IRR can be flattered by timing; a quick refi or early sale can inflate it without creating durable value. Equity multiple grounds performance in absolute dollars.
How to use it: Pair equity multiple with IRR length. A 1.9× over 7 years may be better risk-adjusted than a 1.7× over 3 years that relies on aggressive exit assumptions. Ask for quarterly cash flow waterfalls to see whether the story is front-loaded (financial engineering) or earned via operations.
2) Yield on Cost vs. Market Yield (the “Value-Add Spread”)
What it shows: Stabilized Net Operating Income (NOI) divided by all-in basis (purchase + capex + financing costs) compared to prevailing market cap rate on the exit date.
Why it matters: The spread between your yield on cost and market yield is creation alpha. If you can stabilize at an 8.0% yield when the market trades at a 6.0% cap, you’ve built a 200 bps margin of safety.
How to use it: Pressure-test rent and expense assumptions that drive stabilized NOI. Beware projects where the spread disappears unless you underwrite rosy rent growth or zero cost overruns.
3) DSCR and Debt Yield (Not Just LTV)
What they show:
- DSCR (Debt Service Coverage Ratio): NOI / annual debt service; signals ability to pay the mortgage through cycles.
- Debt Yield: NOI / loan amount; a lender’s quick proxy for collateral strength, independent of interest rates.
Why they matter: LTV hides repayment risk when rates fluctuate. DSCR and debt yield highlight resilience under stress.
How to use it: Model DSCR under downside scenarios (e.g., −5% rent, +50–100 bps rates at refi). For transitional business plans, target DSCR ≥ 1.25× at stabilization and debt yield ≥ 8–10%, depending on asset and market.
4) Breakeven Metrics (Occupancy, Rent, and Rate)
What they show: The point at which the asset stops covering costs or covenants.
Why they matter: Breakeven occupancy and breakeven rent reveal how much slack the business has before distributions halt or a capital call looms. Breakeven interest rate at refi tells you how much rate pain you can absorb if exit slips.
How to use it: Require a downside case with explicit breakevens and liquidity plan. A breakeven occupancy above historical troughs in the submarket is a red flag. Align reserve sizing and capex pacing with these thresholds.
5) Sensitivity Matrices and IRR Attribution
What they show: Return convexity—the slope of outcomes when key variables move (rent growth, exit cap, capex, timing, interest rates). Attribution breaks IRR into components: cash flow from operations, leverage effect, multiple expansion, and timing arbitrage.
Why they matter: Two deals with identical base-case IRRs can have radically different risk: one dependent on exit cap compression; the other driven by tangible NOI growth.
How to use it: Ask for two-way tables (exit cap × rent growth) and a tornado chart. Favor projects where most value comes from durable NOI gains and prudent leverage, not heroic multiple expansion.
6) Cash Conversion and Reserve Adequacy
What they show: The proportion of NOI converted into distributable cash after recurring capex (R&M, turns, minor upgrades) and true operating needs. Reserves (operating + capex + interest/lease-up) form the shock absorber.
Why they matter: Reported NOI can overstate economic cash flow if recurring capex is minimized. Thin reserves magnify small misses into covenant issues.
How to use it: Normalize for recurring capex by vintage and asset type; demand a reserve policy (starting balance, triggers, replenishment). Prefer plans that build cushions early via disciplined distributions rather than extracting every available dollar.
Putting It Together: A Practical Scoring Framework
Build a weighted checklist around the six metrics:
- Value creation (Yield-on-cost spread, Equity multiple) – 35%
- Balance-sheet durability (DSCR, Debt yield) – 25%
- Resilience (Breakevens, Reserves) – 25%
- Model robustness (Sensitivities, IRR attribution) – 15%
Insist on three cases (downside/base/upside) and a dated underwriting model. Re-score deals after any material change—debt quote shifts, capex repricing, or leasing surprises.
Questions Sophisticated LPs Ask Before Wiring
- Which two variables explain most of the IRR, and how fragile are they?
- What DSCR and debt yield do you underwrite at acquisition and stabilization?
- What’s the breakeven rent and occupancy, and how does that compare to the last recession in this submarket?
- Show the yield-on-cost vs. market yield under realistic rent and expense ranges.
- How are reserves sized, governed, and replenished—and who must approve draws?
- Provide two-way sensitivity tables and an IRR attribution breakdown.
Cap rate can start the conversation, but these six metrics finish it—by translating stories into numbers, and numbers into informed conviction. If you’re leaning into larger or more complex projects, thoughtful real estate investment partnering—with transparent models, disciplined reporting, and shared downside rules—can make the difference between paper returns and durable outcomes.
