High Equity Multiple but low Levered IRR
We're looking at a Class A Office to Resi Conversion in primary market and looking at return metrics. The deal has an 7-9% levered IRR, but an equity multiple ranging from 1.7-2.1, which is pretty solid. Why is this- what does this relationship tell you? What are ways to boost IRR?
I think in part because of the high acquisition cost and high interest rates.
That’s a function of timing. You need to shorten hold to boost irr.
This, or delay capital outlays. Your IRR is a function of how much money you have outstanding over the life of the project. If you have a fund using your subline will juice that IRR, but firms usually just keep that in their back pocket, not something used during UW.
Cash out refi, duh
IRR is based on time value of money so if the deal is being analyzed over a long time the IRR is going to be lower and EM is just a static return of capital over the span of a whole investment. If you want the IRR to go up then either increase cash flows, shorten the time horizon, or reduce initial costs.
Without seeing the underwrite and knowing that it’s a conversion, I can make a best guess that this deal probably doesn’t cash flow well (if at all), involves a lot of initial capital outlays (as someone said above), and has all of the return of capital + profit returned at the end. In order to fix this I would try to do anything that could return capital earlier in the life of the deal. This could be (I) doing the deal in phases to get some amount of initial recurring cash flow, (II) fund improvements with debt or delay capital calls with a LOC, and/or (III) shorten your hold period (plan to flip as soon as converted or refi as soon as converted). I have seen some conversion deals do cash our refis after completing 1 or 2 phases of their conversion plan. Also, I would caution that since all of your return is based on the residual value (and not any periodic cash show), you should really scrutinize the exit value assumptions. Make sure this is a marketable end product or else your stuck with a bad deal.
Thanks for the suggestions. How would you split the deal into phases? I saw one group put the acquisition and design as one phase and then construction as another. 2 separate raises. Any other ways to split this? The deal does cash flow after developer fee gets paid (4% cash on cash each year until sale)
Hard to say without understanding the context of the deal. You can phase it the way you described (e.g. initial investors are in for the land development/entitlements and get taken out when you go to build based on the improved land value) - this needs to be a fit for your investor profile though, and if you're going to segment this way you need investors interested in both sides of the deal/risk profiles and not cradle to grave.
You can also phase a deal based on the structures themselves - e.g. if there are multiple towers, you're building townhomes, etc. each one is a different phase.
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