Rough mental return calculations?
Hi all,
I'm looking to improve my "deal sense" and am wondering about simple mental math calcs I can do to get a sense for returns when talk about deals?
For example: Entry cap+constant growth rate=IRR (assuming same exit cap). So buying at a 5 cap with 3% growth over the hold period and exiting at a 5 cap would earn an 8% IRR.
Are there are other calcs I can do to get a sense for how leverage would affect IRR? Or how IRR might change with exit cap expansion/compression? Or any other tricks generally to get a sense for how a deal might return?
Thanks!
Valuing a property with a cap rate is really just valuing a perpetual cash flow. V = NOI/Cap Rate. Perpetual cash flow is V = CF/(Discount Rate - Growth Rate). So Cap Rate = R - G.
Only caveat here is don't forget CAPEX. Including normalized CAPEX will result in a lower "real" cap rate and ultimately lower IRR. Also, this may be obvious, but want to point it out for others who may not already know, the other thing is this would only translate to unlevered IRR. Levered IRR's would (should) be higher since you should have positive leverage and will vary depending on amount of leverage and terms.
To expand on RE Dev's answer.
In a world without TIs/Capex, downtime, lease-up, structural vacancy, broker fees, DD costs, etc., the unlevered IRR should be: Unlevered IRR = Cap rate + G.
If you add leverage, the return should be higher (most cases), and can be approximated as follows: Levered IRR = Unlevered IRR + (Unlevered IRR - Financing cost) x Debt / Equity. The wider the spread between the unlevered returns and the financing cost, the more favorable leverage will be. As debt increases, the multiple gets more significant, but a higher LTV usually means higher financing cost. Keep in mind that this is the IRR before tax.
Another way too look at this formula:
cost of debt x debt% + cost of equity x equity% = WACC
cost of equity = (WACC - cost of debt x debt%)/equity% = (WACC x (equity%+debt%) - cost of debt x debt%)/equity% = (WACC x equity% + (WACC - cost of debt) x debt%)/equity% = WACC + (WACC - cost of debt) x debt%/equity%
WACC is unlevered IRR, cost of equity is levered IRR, and cost of debt is loan constant or interest rate
I've noticed that all of the big shotcaller principals I've dealt with in my career don't give two fucks about IRR (pre-disposition obviously) on development deals. Too many variables including exit cap-rate, hold period (when is stabilization and when is the right time to sell?), and debt service (if floating rate).
All they focus on is months to stabilization, development cost per pound (pu, psf, pb, etc...), and stabilized YoC. Having a strong YoC over all else gives you optionality on the exit whether that is disposition or refinance. Levering up to the hilt and trying to sell immediately with minimal development spread to engineer a high IRR is risky business that does not allow for uncertainty.