Hi all,
Would like to seek your professional advice and help. I'm an first year investment analyst in a real estate developer firm. Being a real estate developer instead of a fund/private equity, our strategy is mainly to purchase coreplus, value add or greenfield projects and hold over a long horizon.
Given this investment strategy in mind, my bosses suggested that using IRR as an investment metrics may not be so suitable for us as we are holding over a long horizon (more than 5-10 years) hence, it wouldn't make sense to project an exit value of the property, and using ROI would be better. With this, i would like to ask, when i receive deals, what will be a good ratio/metrics to look at?
Thanks
Sorry you said you work at a development firm that buys core-plus for long-term hold with some value add? Just want to make sure I'm reading it correctly - as most development / merchant builders I've come across buy land, develop, and flip very shortly after they hit their lease-up parameters. In my limited experience, say for MF development deals, from breaking dirt to sale is typically a 3 year hold period...
Assuming you want to know the best metric for analyzing a long-term hold asset, I agree with your bosses that IRR can be a bit tricky here. Being that IRR/XIRR is time-sensitive, long term holds can start to not accurately depict the returns on the project. This is often why GP's on term sheets for development will attach an Equity Multiple to the IRR hurdles, to protect themselves should the project take much longer than expected to sell.
As for the best metric? Id agree that ROI or more specifically ROE is the best bet. Its also common for long-term hold shops to use NPV and cap it via a 10yr DCF model... Being that you're in a development field, I'd also track your DSCR depending on the type of credit you all use (assuming 10-30yr floating/fixed with some IO provisions?).
However, regarding IRR, you might still NEED to track this. Not sure how your JV structure looks, but if it's like most development shops you likely get term sheets that outline waterfalls based on hurdles, which are usually based on IRR. Thus, even if you wish to use ROE/ROI as your main metric of U/W / Dispo analysis...you will need to track project level IRR to see which hurdles the deal is projected to clear, in order to determine the amount of equity you will earn in order to back into your ROE metric...
Hope this helps!
Mainly I would say it depends on two things, what do your investors want? and how is your firm compensated?
But overall I agree with Post Hoc. My firm only does MF value add (5+ year holds) and we look at Cash on Cash, IRR, and EM. These are all largely dependent on your initial cap rate, $/SF, $/Unit, loss to lease, and how fast you can turn over the units.
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definitely yield on cost. Look at your yield relative to your exit cap assumptions and determine whether there is a sufficient spread to justify the risk premium. What are you building to relative to where comparative assets are trading? That is the ultimate sniff test.
You can also use IRR to show what the returns are if you were to hypothetically sell the asset at stabilization. So, maybe you have a three year development period, lease-up, and cap your stabilized income (4-5 year model). This can help position a long-term a development asset analysis in the same context that a future buyer would evaluate when buying a new construction deal.
Once you start messing with 10 year hold analysis, etc. you are just blowing smoke out of your ass. Nobody knows what is going to happen to financing costs and cap rates two years from now, let alone 10. When you consider that the PV of a long term analysis may be 30%+ based on reversion value, you can obviously cook those assumptions to spit out whatever returns (and story) you want.
I agree with Ricky. Project your yield on cost and stabilized cash-on-cash (to understand the impact of your financing, and uh, what you actually get back each year you hold the asset). I'm sure there's no right way to do it, but if I were a developer intending to hold my projects long-term, those would probably be my primary metrics.
I agree with your comment about DCF approaches...The concept of projecting something out 10 years, just to apply a discount rate to bring it back to where you started, does seem a little foolish at times. But what would you recommend for asset types like office/retail? Let's say you are selling a building that is 30% occupied...if you take a F12 and cap it your value will be nothing...basically giving it away at BookValue. But as a seller of this asset wouldnt you want to be compensated for all of the future cash flow the asset would generate? Surely it wont be 30% occupied forever? so how do we do this other than applying leaseup assumptions via a 10yr DCF model? Looking at mirror of this example poses the same issues. Say you own a class A 100% occupied asset with three main large tenants...Let's assume the rollover risk is high as 2/3 tenants blow out this year...Again, your F12 NOI capped will be nothing...but run that SAME calc 12 months earlier, and its a completely different result.
Again, I agree that DCF has its inherent flaws, however in the retail and office space I have yet to really come up with a better QUANTITATIVE approach. If nothing else, most valuation companies, auditors, large cap firms use a DCF when talking about those two asset types.
If not for nothing, at least most groups will blend it with some type of sales comp approach....
When I am evaluating long term holds, one thing I always make sure to emphasize is at what period in time will we receive a full return of our capital and what assumptions it takes to get us there. The sooner we receive back all our original investment the more we like the deal. What leads to the return of capital can greatly vary on a deal by deal basis, but understand what it takes to achieve this milestone helps greatly in our analysis.
I think CoC yield are useful In determining long term holds. You can model it out based on market Rent assumptions without speculating on Cap Rates appreciation/depreciation. looking at stabilized value is also useful as with a REFi that cash out is tax-free although it can lead to untoward tax liabilities in a case of a default as that CF can be looked at as profit.
I was thinking about that earlier. How does the default process work on a non-recourse refi w/ cash out, if the borrower takes the cash and spends or reinvests it? The bank takes the collateral, but what type of blow back does the borrower have on the cash taken on the refi?
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