I am looking at a value add multi-family project with a 5 year hold. We have to buy the property as the seller won't sell us the next door development site unless we purchase this one.
We would be buying in at a 5.7 cap and selling at a 5.4 cap 5 years later. Why is it that the longer I hold the more the IRR goes up? Is it due to the tight spread between entry and exit cap? how do I articulate this in an intelligent way?
Edit
Thanks!
Exactly. I made a wordy version below.
this doesn't explain why his IRR is increasing with a longer hold.
The only way this is possible is if the NOI is increasing at a higher annual rate than his IRR, in which case something is messed up in the model or he is using VERY aggressive assumptions
Not necessarily true. Let’s assume you get a 20% return on equity each year (cash on cash). In 5 years you’ve recouped your investment. In 6 years you will have surpassed a positive IRR and it will keep growing as each period passes. It’s a function of time and return. Of course growth rates create a portion of the return function, but growth rates are a piece of a function of what makes up return.
Essentially stabilized cash-on-cash is higher than XIRR so longer hold pushes XIRR closer to stabilized cash-on-cash. If you want to be conservative stop inflating rent growth after year 3 and use a 4% inflation for OpEx.
I’ve been curious about this. Do a lot of MF value add groups model unit renovation and down time as leases expire? Or do most assume $x/unit renovation cost up front with 5% rent growth thereafter?
Down time as leases expire, 1-3 months maybe. We would usually keep growing base rent at 3% or w/e but add a flat "renovation premium" on top of $50-150/unit usually...
you should be able to defend why you believe yields will compress over the next 5 years; i could easily argue otherwise.
I'll put my money on yields compressing over the next 5 years all day. America can't afford for them to rise with nearly $24T in debt and theoretically have cushion to lower yields further considering Germany, France, Japan, Sweden, etc... are all selling negative rate bonds...
If i were to take all of the statements you mentioned at face value, there'd be a lot to unpack. Not sure I'm putting my money on something "all day" any time soon
Why are you thinking you'll sell for a lower cap?
Yeah that jumped out at me too, but I didn't know if that was standard for value add guys or not.
It's not. Good rule of thumb is 10 bps of cap rate expansion per year.
Same question. I like to see a little cap rate conservation for that reversion at the end of the hold. Or just use the going in cap rate if you "wanna be aggressive." Building in cap rate compression at this point of the cycle could make a fun conversation.
OP sounds like my prior employer. always buying deals and using 50 to 100 bps lower exit cap without taking into account consideration for why folks use a cap rate spread from market. They solve for 18% IRR across core or value add deals, helpS them to raise money from greedy peeps that see 15%+ IRR on paper not knowing they are buying a deal that's under water from day one but they syndicate funds and load the deal up with fees!!
i can't wait for them to get smoked when the market turns!
i hope american doesn't turn into negative interest rates, that would be scary for your average joes and the wealth gap will get worse!
not sure how cap rates can get any lower but time will tell in key coastal markets unless we get a new BIG tech that drives growth over the next 10 years.
Of course they will lower rates further, maybe even negative. Do you think the elites will stop rigging the game and take a massive asset write-down? Ha! Texas is already preparing...
https://www.texastribune.org/2018/06/06/gold-depository-texas-bullion-g…
https://www.bizjournals.com/austin/news/2018/12/17/texas-fort-knox-dirt…
Even with a declining terminal cap, the IRR should still be lower on the longer hold. What are the other assumptions? something sounds off… I can’t imagine yield > IRR on a 5 cap value add.
It really depends how much you are looking to raise rents and on what timeline. If there are a lot of units (100+) and they are substantially below market currently (~10-20% ) then your NOI should be growing at a good rate for a few years as you renovate units when they become available and build the cashflow of the property. If your NOI is growing at a good rate year over year then your exit value should be climbing as well (let's ignore the cap rate issue that others have raised). It would have to be growing faster than your shorter term hold IRR for the IRR to be climbing though. For example, if your 3 year case is an IRR of 12% you need to be growing your NOI more than 12% (well, close to it) year over year in years 4 and 5 for the IRR to be higher for longer hold time.
If your NOI is not growing faster than your IRR but your IRR is still climbing then you may have issues with your model.
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