How are you guys doing, Im expanding on something I read here recently, I have an repe interview coming soon and need help with some real estate technical questions. I know real estate fundamentals such as cap rates, dcf, valuation methods but sometimes I have trouble with the technicals. Someone asked this recently:
If you have an LTV of 75%, a cap rate of 4% and a 3% interest rate, what is your ROE?*
I see this question as an IB/PE on-campus recruiting style question, something a fresh grad would know cold. Problem is I haven't done those in years so Im reaching out for some help and for some examples.
What are some typical questions that you guys have come across? (does anyone know a good one for IRR?)
Uhh, if you're assuming interest-only then it's a pretty simple calculation:
$100 value $75 of debt $25 of equity
Cap rate of 4% = $4 of NOI Interest-only rate of 3% = $2.25 of interest
$4 NOI - $2.25 interest = $1.75 net cash flow.
$1.75 / $25 = 7.00%
That's way basic and not really how one would analyze returns, but since you asked the question...
why are you paying interest in the equity too? am i missing something? sorry if i am
thanks DCD....correct me if im wrong but Interest expense is 2.25% (75% * 3%). Thus, return should be 1.75% (4%-2.25%). i was looking for other examples but thanks as I'm sure this'll help a ton of ppl on here.
This is a simple levered return question and the formula below will be really useful for back of the envelope analysis as you look at deals:
Levered Return Formula:
Unlevered yield + leverage ratio*(spread between unlevered yield and cost of funds)
Unlevered yield = 4% cap rate Cost of funds = 3% interest rate Leverage ratio = 3x (75% leverage = 3 parts debt :1 part equity)
Levered Return (or ROE) = 4% + [3*(4%-3%)] = 7%
great..do you know of a simple IRR question they might ask? anything to the effect of ltv is 80%, purchase price is 20m, cf is xxx? I forget how those questions are usually phrased and it would greatly help for some examples.
I don't think you'd be asked an IRR question on the fly like that. The math isn't difficult, but tricky to do in your head unless you're a human calculator. You might get something super simple like - "if I give you a $100 today require a 10% IRR on my investment, how much do you have to pay me back in two years?" - Most want to say $120, but it's $121 because of the compounding....very basic
What if the spread between unlevered yield and cost of funds is negative.
That'll be true in certain scenarios such as development deals and projects with significant cap ex or lease-up. In a real world situation if your NOI pre-stabilization cannot meet debt service, those obligations will be either funded through equity proceeds - that is part of the project's capitalization or in the case of a development, paid from the construction loan.
If you're buying an asset at a cap rate (yield) less than the cost of funds, you have negative carry. This is frequently the case in re-positioning/development deals.
In this scenario, you wouldn't be able to use the back of envelope formula described. You'd have to figure out the cash flows (e.g. Yr 0: -100, Yr 1: 10, Yr 2: 111) and back into your IRR that way. Unless the numbers added up easily, like in my example (10% IRR), this would be outrageously challenging to do in an interview.
Yeah, my bad. I responded on my way out the door. Good catch. Edited.
How would you guys answer this question:
Given a office and a hotel in the same submarket, with similar characteristics such as revenue/expenses/building size, which asset would you expect to have the higher cap rate?
Hospitality is generally going to trade at a higher cap than office due to the volatility in income (no long term leases, rent rates can fluctuate rapidly). However, it seems like there could be certain submarkets where that's not true. Miami comes to mind as an obvious example.
Impossible question to answer (or it's a trick question meant to bring out your understanding--or lack of understanding--of the different property profiles). The only real correct answer is that it depends on the market and it depends on the submarket. A Residence Inn in the exurbs off the interstate might trade at a much lower cap than an office building in the same location. Also, the hotel flag makes a BIG difference in desirability.
One could say that GENERALLY hotels trade at higher caps. It's possible that an interviewer would be asking a prospective analyst for the generally correct answer to see if he/she knew the basics.
I think the answer to that question is "Almost universally, hotels" - the reason being that hotels are essentially real estate assets with an operating business. Most real estate - office, retail, multi - is plug and play (more or less).
You sign a lease, collect rent, and maintain the physical building. Hotels on the other hand have to be operated - whether they're occupied or not - and are inherently more volatile since the revenue stream has no duration (office tenants sign long term leases; hotel guests pay per night). Less stable cashflow = harder to project future CF = higher cap rate
For those of you who are just starting out: higher cap rate = lower multiple
Hotel. Office is boring AF whereas Hotels are fun AF
Hospitality can be struck down by a bad economy overnight (canceled business trips, immediate layoffs, cut down in business development endeavors, decrease in vacations). Offices have longer leases and will most likely ease into a recession baring company default. Hospitality business was absolutely crushed in '08 and has only recently recovered whereas office seemed to be marginally more resilient (but by no means unaffected). The increased risk in hospitality will push the cap rate up a bit--giving investors an extra point or so for a risk premium.
Caveat: I do zero hospitality. Some real estate gurus out there don't think hospitality is true real estate but actually an alternative business that is run within a real estate shell.
OP, how did the interview go?
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