Buildup Rate
An alternative method for arriving at a capitalization rate for a real estate investment. The buildup rate is the sum of all risks of an investment (denoted in percentage) plus the risk-free interest rate.
For example:
Risk-Free Rate (e.g. 10-yr UST): 2.25%
+
Illiquid nature of investment: 0.75%
+
Credit risk of tenants: 1.25%
+
Inflation risk: 1.00%
+
And so forth…
=
Buildup rate: 5.25%
Putting ‘Buildup Rate’ in Context
Scenario:
Andean Development Group, a Bogotá-based real estate developer, is approached by a major international third-party logistics (3PL) firm to develop a state-of-the-art fulfillment center. The facility, named the Bogotá Fulfillment Center, will be a build-to-suit industrial warehouse located on the outskirts of Bogotá, Colombia, strategically positioned to serve two large e-commerce companies entering the Colombian market. Given the lack of readily available cap rate data in this emerging market, Andean Development Group must determine a suitable stabilized yield-on-cost using the buildup rate method.
The Challenge:
In Colombia’s evolving real estate market, especially in industrial sectors like warehousing and fulfillment, reliable cap rate data is sparse. The 3PL client has agreed to a 15-year triple-net (NNN) lease with annual rent escalations, targeting a stabilized yield-on-cost that is 200 basis points above the prevailing cap rates. However, since market cap rates are not easily accessible, Andean Development Group decides to calculate the appropriate capitalization rate using the buildup rate method.
Buildup Rate Calculation:
To derive the required cap rate (stabilized yield-on-cost), Andean Development Group considers the following components:
- Risk-Free Rate: The yield on the 10-year Colombian government bond, as of August 20, 2024, is approximately 9.852%.
- Illiquidity Premium: Given the nascent state of the industrial real estate market in Bogotá and the specialized nature of the asset, they assign a 0.5% premium.
- Credit Risk of the 3PL Tenant: Although the 3PL firm is a large international player, the two e-commerce tenants it serves are relatively new to the market, prompting Andean to assign a 1.0% credit risk premium.
- Inflation Risk: Colombia’s inflation is relatively high compared to more developed markets, so Andean factors in a 2.0% inflation risk premium.
- Property Type Risk: Given the specialized nature of the industrial property and the unique demands of a build-to-suit fulfillment center, Andean assigns a 1.0% property type risk premium.
Adding these components together:
Buildup Rate = 9.852% + 0.5% + 1.0% + 2.0% + 1.0% = 14.352%
Target Yield-on-Cost:
Since the developer wants to achieve a yield-on-cost that is 200 basis points above the perceived market cap rates, they adjust the buildup rate accordingly. Assuming the buildup rate reflects the perceived market cap rate in this context:
Target Yield-on-Cost = 14.352% + 2.0% = 16.352%
Conclusion:
Andean Development Group now has a target stabilized yield-on-cost of 16.352% for the Bogotá Fulfillment Center. This rate provides a cushion above the perceived market risks and ensures that the project meets the firm’s return thresholds despite the challenging and opaque market conditions in Bogotá. The buildup rate method, while less commonly used in highly transparent markets, becomes a crucial tool in this scenario to assess and justify the expected returns on a development project in an emerging market with limited data availability.
Frequently Asked Questions about the Buildup Rate
What is the buildup rate in real estate investing?
The buildup rate is a method of estimating a capitalization rate by adding a risk-free interest rate to various risk premiums associated with a specific real estate investment.
How is the buildup rate calculated?
It is calculated by summing the risk-free rate and premiums for risks such as illiquidity, tenant credit risk, inflation, and property type. For example: 9.852% (risk-free rate) + 0.5% (illiquidity) + 1.0% (credit) + 2.0% (inflation) + 1.0% (property type) = 14.352%.
When is the buildup rate method typically used?
It is typically used in emerging or opaque real estate markets where reliable cap rate data is unavailable or inconsistent.
How did Andean Development Group apply the buildup rate method?
In evaluating the Bogotá Fulfillment Center, Andean added risk premiums to the 10-year Colombian bond yield (9.852%) to arrive at a buildup rate of 14.352%, then added a 2.0% margin to target a yield-on-cost of 16.352%.
Why is a risk-free rate used in the buildup rate calculation?
The risk-free rate represents the minimum return an investor expects without taking on any risk. It forms the base of the buildup rate, with additional premiums added for specific risks.
What does a high buildup rate indicate?
A high buildup rate reflects higher perceived risk and required return, often due to factors like market uncertainty, inflation volatility, or weak tenant credit.
How does the buildup rate relate to yield-on-cost?
The buildup rate helps establish a target yield-on-cost. In the Bogotá example, the developer sought a yield-on-cost 200 basis points above the buildup rate to meet return targets.
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