Need some help with my model.
For some reason my IRR is increasing with a longer holding period. Cannot for the life of me figure it out.
My NOI is increasing steadily post-stabilized period, and everything else grows as should. IO of 60 months, fixed rate.
Any ideas as to why a model would do this?
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What kind of annual rent bumps are being modeled? My initial hunch is that the residual value must be increasingly outsized as the hold period goes on.
3% across the board, same with opex
Why is this surprising? Presuming this is some form of development or value-add deal (based on the stabilization comment), you probably have some cap rate spread/developer's profit (ie. build on 8% cap, exit value at 6%), thus with growing NOI you can easily magnify returns due to the growing cash flow and growing exit value. Just calculate annual income yields and appreciate returns to see if this is logical. The loan spread will also make a huge deal, wider it is, the more cash flow grows with each annual increase.
Really, this doesn't sound surprising, especially if you use same exit cap rate for the analysis across the years.
The deal would have to generate cash on cash returns that outstrip your IRR, which is what would be required to create this phenomenon. I don't think there are many development deals that would be pro forma'd this way... and the higher the IRR gets the harder it is to sustain this, it's more likely an error in the model.
It just depends on the spreads (development profit/cap rate spread, and debt spread), but it is very possible if you wide margins. Eventually accumulated equity value will over power this and IRR will decline, but if you have wide spreads and enough growth, it's completely mathematically possible.
Hint, just do annual IRR calcs until you get an inflection (assume you have error checked as first step).
Not sure why this is so surprising to everyone, basic law of math with IRRs, if you ever seen an "IRR graph" this will make more sense.
That said, it is usually most accretive to bang out (sell, recap, refinance) sooner than later. I wonder if the terms of the IO for 60 months are driving this, many loans flip to being amortized upon stabilization (for the mini-perm), if you keep it IO, that is just more cash flow!
Sounds like there could be an error somewhere. If the asset is stabilized and both growth and expenses are growing at the same rate an earlier exit should return a higher IRR (especially with 60 month I/O) is your exit cap compressing significantly yoy?
I get this in bad development deals when the stabilized irr is so bad it can only go up
This made me lol and get a little depressed at the same time as I've seen this happen in reality too (obviously never in pro forma or you wouldn't do the deal).
LOL, like deals that only savior is debt paydown!
I imagine you're looking at a development deal where there is a small development spread between your day one, ungrown, yoc and assumed exit yield?
If so, your returns are being driven by the growth so an uplift is possible over a longer hold.
This happens from time to time, especially in the instance where the returns of the deal are more dependent on cash flow than appreciation. At some point if you are increasing the hold period 2, 3, 4 years out into the future you should be adjusting the cap rate upwards.
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