CAN YOU BUY A CUP OF COFFEE WITH THAT HIGH IRR?
A growing number of real estate investors see a high-projected IRR (Internal Rate of Return) on Value-Add*** offerings compared to the Core* or Core Plus** cash yield deals and jump quickly to conclusions. However, the more prominently displayed IRR might include a large degree of assumptions that are reliant upon a lot of things all going according to plan. (You know what they say about assuming).
IRR does not truly capture the risks taken by Sponsors/Investment Managers to achieve the projected returns. It is also a metric that can easily be manipulated by those same Sponsors to show a high return number that may be impossible to deliver given market conditions, rising construction costs or lack of experience on the part of the manager.
In reality, it is important to analyze a deal by looking at the picture in its totality, placing an emphasis not only on the IRR but the cash yield components, as well.
There are three primary ways to evaluate a real estate investment:
1. Cash-on-Cash Return
2. Internal Rate of Return
3. The Equity Multiple
In this article, we will discuss the pros and cons of each of these methods to help you determine if a real estate investment is right for you.
Calculating An Internal Rate of Return (IRR)
Investors should look at inflation as a “hidden tax” that reduces the purchasing power of your money.
The annual inflation rate in the United States is now running at close to 5.0% from the 12 months ending in May 2021. Therefore, if your money isn’t growing by 5.0% you are losing REAL money on this hidden tax. Will inflation continue to grow or stay relatively high in the future? Truth is, no one knows. HOWEVER, there are clues that help tell us that it is probably here to stay.
Related Resource: How to Utilize Commercial Real Estate for Taxes
At its core, the Internal Rate of Return (IRR) is the annual growth rate that an investment is projected to return to the investor. In a more technical sense, IRR is the discount rate at which the Net Present Value (NPV) is equal to 0. Let’s break that down:
● Net Present Value (NPV):
Net Present Value (NPV) is the current value of an investment based on future projected cash flows, including the value of the investment at the end of the hold period or life of the investment.
● Discount Rate:
A Discount Rate is used to discount the future value of an investment on an annual basis to get it to its present value; it is the rate at which the purchase price would yield that rate of return. In practice, an investor would pay $X today for an investment to achieve the discount rate, or rate of return.
The Weighted Average Cost of Capital (WACC) can be used as the discount rate. WACC is the cost of doing business based on the combination of the costs of using debt and equity. If an IRR exceeds the WACC, then the investment itself may be deemed feasible because your projected return is higher than your cost, meaning you make a profit. Use WACC so you don’t get WHACKED!
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The Internal Rate of Return Formula
Yes, a spreadsheet provides us with the tools to calculate IRR with ease, but understanding the nuts and bolts of the IRR formula is important to grasp the concept and its application when evaluating a deal. The IRR formula is as follows:
Ct = Net cash received during time period t
C0 = Total initial invested equity
IRR = The Internal Rate of Return
T = The number of time periods
Internal Rate of Return is a more complex calculation compared to calculating the Cash-on-Cash return or an Equity Multiple. IRR also requires an analyst to make certain value judgments on the investment, such as the estimated property sales price, rental growth rates and the discount rate.
Even if the Cash Flow assumptions are 100% correct, too low of an exit Cap Rate (too high of a sales price estimate) or an inaccurate annual growth rate on rents can skew the returns to look more favorable than they actually would be. IRR typically has high sensitivity to growth rate assumptions and exit value, meaning the investment is more difficult to project given the uncertainty of future markets.
When utilizing the IRR function in Excel, replace the =IRR function with =XIRR, particularly when using monthly cash flows. The XIRR function uses specific dates and an extended formula to more accurately model unevenly timed cash flows.
Related Resource: Commercial Real Estate Statistics and Trends 2021
The Equity Multiple is another common return metric in evaluating an investment, representing the total profit achieved from annual cash flows plus sale proceeds as a ratio against the total equity invested (formula below).
For example, if you invest $100,000 in a deal and receive $10,000 every year over 5 years in annual cash flow and $150,000 in sale proceeds, you would have $200,000 in distributions. In this example, your Equity Multiple will be 2.0X (or two times the money you invested), or 2 times your initial investment:
What is the difference between the Equity Multiple and IRR?
The IRR is a metric that represents the annual rate of return during various periods as a percentage of the total dollars invested whereas the Equity Multiple provides the actual profit received in cash distributions against your invested equity, or total cash return on your investment. While IRR allows you to see the rate of return as a percentage, the Equity Multiple gauges how much total profit is received in cash distributions and indicates how much you should expect in your bank account at the end of the investment period.
Both the Equity Multiple and the Internal Rate of Return include the value, or sale price, of your investment at the end of your hold period. However, one of the core benefits of investing in Real Estate is the annual, or monthly, cash flow received from the investment.
So, how do you isolate the annual cash income received from an investment without considering fluctuations in the future value of an investment?
The Cash-on-Cash (CoC) return does just that and allows you to evaluate the annual net cash flow without considering the sale price, which is most likely to fluctuate. In this metric, each year’s total cash flow is represented as a percentage of the total equity invested, as shown below:
Before we move any further, let’s evaluate how we get to the annual net cash flow. Net cash flow is the cash flow that remains after operating expenses, capital expenditures and any payments on mortgage debt.
Simply stated, the net cash flow is the actual cash in your pocket after deducting total expenses. It is the income earned on your investment every year also known as Yield or your Return. For example, if you invest $1,000,000 and receive $100,000 in net cash flow distributions, your Cash-on-Cash return for that year is 10%.
The Cash-on-Cash return can be evaluated on a per-year basis or as the average annual cash return over the life of the investment. This metric is one of the most valuable returns to consider, especially when annual or monthly cash in pocket is important to you as an investor.
Related Resource: Ultimate Guide to Passive Income Real Estate Investing
The Importance of Cash Yield
While investors may place a heavy emphasis on IRR, analyzing the quality of a deal requires looking at the whole picture. Prioritizing IRR over both the Equity Multiple and Cash-on-Cash yield can result in overstated returns because IRR is typically sensitive to variable underwriting assumptions. Additionally, changes in capital markets may cause a reduction in the projected sale price of an investment but still generate a favorable annual cash yield.
Let’s look at this in practice:
Assuming only Equity (All Cash) is used to purchase a property, the Cash Flow example below shows a purchase price of $2,000,000, which equates to a 5.00% Capitalization Rate on the Year 1 Net Income (Cash Flow) which is $100,000 ÷ by $2,000,000 = 0.05.
In this example, the analyst assumes that the Exit Cap Rate will decrease to 4.75% (a higher sales price) at sale by 25 basis points (0.25%), yielding a higher disposition price as a result of the lower Exit Cap Rate and the cash flow’s growth.
Example Of All Cash IRR and Cash On Cash Analysis:
The initial investment of $2,000,000 yields an IRR of 14.5%, Equity Multiple of 1.88X, and an Average Cash-on-Cash yield of 6.00% over the 5-year investment period.
Now running the same analysis while adjusting the Cap Rate higher (lower property sales price) because cap rates for this type of property have increased (this could be a result of the market area or property type losing favor with investors). In this situation the capital markets dictate that the Cap Rate should be 5.25% upon exit, or an increase of 25 basis points.
The IRR incurred a significant reduction to 12.6% while the investment still maintained a healthy Equity Multiple compared to the Base Case investment analysis. Although the IRR experienced an unfavorable change, the Cash-on-Cash yield remained unchanged because it is a function of the cash flow performance and, therefore, not impacted by changes in assumptions used in the analysis of market conditions upon exit.
In summary, look past the high IRRs that can be manipulated by non-existent rent increases, excessively low exit cap rates along with unrealistic discount rate usage. Analyze the entire investment and emphasize the cash components of a deal as well as visualize the benefits of alternative investment strategies.
As a long time friend Matt Bear of Bear Realty Advisors told us over lunch one day “You can’t spend IRR, but you can spend cash flow!”.
Core real estate investments are the safest type of investment presenting the least risk risk to an investor’s capital/equity. Core properties are usually recently built or have leases with tenants that have the highest credit ratings. Core investments are at the base of an institutional grade portfolio and while delivering lower returns will be the foundation for wealth creation and preservation.
Core Plus investments involve good – not great – properties with a chance for a slightly higher return through income and some growth.
Value-add returns offer income and growth.
Value-Add* offerings compared to the Core** or Core Plus***.
Value add real estate is property that requires some improvements in order to increase its value. Such investment properties can be rundown due to the owners lacking the finances to make improvements or just sheer neglect.
If you are interested in how Liberty Real Estate Fund can provide you with Stable and Tradale, Dependable Monthly Cash Flow backed by Bonds wrapped in real estate contact us HERE to schedule a call to learn more.
*Note: Liberty Equity Management LLC/Liberty Real Estate Fund I LP (Liberty) have made every attempt to ensure the accuracy and reliability of the information provided. Liberty cannot not accept any responsibility or liability for the accuracy, content, completeness, legality, or reliability of the information contained herein. The information herein considered legally binding legal advice, tax guidance, or financial counsel.
Jordan Steck, MSRE, is a Principal and theVice President of Portfolio and Acquisitions of Liberty Real Estate Fund I LP, the World’s First Net Lease Security Token Fund. Jordan, is a pioneer in Real Estate’s new Liquidity Protocol using Digital Securities Offerings on Blockchain. Previously, Jordan boasts commercial real estate underwriting and asset management experience for major publicly traded Real Estate Investment Trust (REIT) across an array of asset classes including: super regional malls, shopping centers, mixed-use multifamily, office, hospitality and Net Lease portfolios. Jordan has extensive experience with portfolio management overseeing 5 Million+ square feet of Shopping Center investments including re-positioning and redevelopment of Regional Shopping Centers, Power Centers and Out-Parcels across major markets in the Northeast United States. Additionally, Jordan was a strategic operations professional for Class A and Value-Add multifamily properties across the Southeast as well as the Mid-Atlantic. Jordan has a Master of Professional Studies in Real Estate (MPSRE) from Georgetown University.
Jordan been featured as a guest on the Nothing But Net – NNN Show” podcast and is host of the popular YouTube series: Liberty Real Estate Analysis Master’s Degree Series