Return potential of a debt or preferred equity commercial real estate investment can be expressed in a straightforward manner: a flat rate of return prevails over a contractually determined period of time or term. The variance in potential return outcomes is not the first thing a prospective investor will look at; rather, the cash yield relative to a unit measure of risk will be top-of-mind.
Equity investments – with uncapped potential upside and a greater range of potential outcomes – require a more nuanced examination of return metrics. The IRR (internal rate of return) is a time-weighted return metric that is common in both financial accounting and real estate investing, where the time value of money and liquidity risk are major factors in investment decisions. Note: EquityMultiple does not make forward-looking IRR projections.
A Numeric, Hypothetical Example
Because IRR is extremely sensitive to the actual, ex-ante hold period of an investment, it is not always useful as an apples-to-apples comparison between two equity investments. If two equity investments entail substantially different target hold periods and, as a corollary, substantively different business plans, IRR may not be a useful device for assessing which is the more appealing investment. Take the example of two hypothetical realized investments:
- A common equity investment into a value-add redevelopment and repositioning of a Class C multifamily property. The Sponsor expects to execute an aggressive project improvement plan, bring rent rolls positive, and exit through sale after a 3-year hold. The Sponsor expects to earn the vast majority of profits through exit, and ultimately hopes to achieve a project-level IRR that would result in a net 20% IRR to LP investors on the project.
- A portfolio of mixed assets, primarily in gateway markets, stabilized, and yielding present cash flow. The manager of the portfolio expects to achieve cash flow and make distributions throughout the term of the project amounting to an annual average of 9% per year across a 10-year holding period with a modest exit resulting in a net 10% IRR to LP investors.
If these two investments play out as intended, the projects will yield a net 20% IRR and net 10% IRR to LP investors, respectively. However, this does not mean that the former value-add project is 2 times as good as the latter portfolio investment. Which one is more appealing, and to what degree, depends on the preferences and strategy of the investor evaluating these two opportunities.
Limitations of the IRR Metric in Real Estate Investing
Here are several dimensions that are critical to real estate investors, but are not expressed adequately by the IRR metric alone:
- Business Plan Risk: Generally risk and return potential are positively correlated; in order to achieve an IRR in the ~20% range, investors will need to assume a higher level risk of principal loss. The project must entail significant business plan execution risk with capital expenditures in redevelopment, while offering little or no cash flow throughout the early part or the entirety of the hold period. This is two sides of the same coin: in order to carry out significant improvement, and thus realize significant appreciation at exit, there must be significant vacancy, and thus room for substantial NOI growth. Or, in the case of a more ambitious value-add redevelopment or ground-up development, the project may require 100% vacancy in order to execute on the business plan. Conversely, a stabilized property (or portfolio of properties) entails significantly less business plan risk which carries less vacancy risk, and less liquidity risk on the part of investors. As such, it generally cannot offer the same opportunity for significantly improved rent rolls and appreciation at exit.
- Interest Rate Risk: Commercial Real Estate transactions generate return in several ways, most often cash flow and exit sale proceeds. A shorter duration redevelopment business plan carries greater interest rate risk due to the majority or entirety of the investment yield being dependent on the exit sale price, which in turn depends on the exit capitalization rate (generally abbreviated as “cap rate”) which the eventual buyer will agree to pay. Cap rates refer to a simple year 1 yield on total purchase price investors are willing to accept and in commercial real estate transactions, while they do not exactly track market interest rates, they are generally very positively correlated. Just as in bond math, a higher exit cap rate would yield a lower project return. Just evaluating the prospective IRR of an investment ignores the timing of the sources of return which generate that IRR.
- Total Yield: Because IRR places such emphasis on time, a large IRR does not necessarily mean a large profit harvested at the exit of an investment. In order to assess the total profit potential, the project IRR must be viewed in combination with the equity multiple. The equity multiple is the simple representation of how much profit was generated in relation to the investment or a whole dollar return on that investment decision. In our hypothetical example above, the breakdown could be as follows:
- Value-add: the riskier project yields a 1.73X equity multiple ($7,280 plus return of principal on a $10,000 investment) after a 3-year hold with no intermediate cash flow.
- Stabilized Portfolio: the significantly lengthier hold period weighs down IRR. While the IRR is only 10%, the investment yielded consistent cash flow throughout (9% per year, an average of $900 on this hypothetical $10k investment). The equity multiple is a more favorable 2.06X, while the investor assumed significantly less risk by participating in a stabilized portfolio of properties which derived its IRR from multiple sources of cash flow (intermediate distributions and exit sale proceeds).
In this hypothetical example, the value-add investment would have yielded an IRR in the neighborhood of 20% (depending on exact timing of exit), significantly higher than the stabilized portfolio. However, the realized total yield and equity multiple of the stabilized portfolio was significantly higher, albeit over a much longer term.
The Bottom Line:
This hypothetical example does not prove that either profile of investment is better, as each should be examined through the lens of the investor’s risk preference. It does illustrate that IRR can be misleading when evaluated in isolation. A single return metric should only be used for apples-to-apples comparison when the risk profile and target hold period of two potential investments are similar. To evaluate more disparate real estate investments, it is more valuable to examine all available return metrics in the context of your investing strategy, risk preference, and composition of your individual portfolio.