Rough mental return calculations?

g0ttag0's picture
Rank: Senior Monkey | 93

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!

Comments (24)

Jan 13, 2019

Bump, interested in this as well.

Jan 13, 2019

Not exactly being a big help here but I told think that Cap + Growth = IRR formula holds true in most cases. I'm curious to hear what others have to say, however.

Jan 13, 2019

Bump, this seems like really great info

Jan 14, 2019

Can you expand on that IRR calculation?

Jan 14, 2019

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.

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Jan 14, 2019

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.

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Jan 15, 2019

You can estimate the cash on cash return by using this formula: cap rate + (interest rate - cap rate) x leverage ratio. For example, if you buy an asset at 75% LTV at 4% interest and a 6 cap, your cash on cash is roughly 6% + (6-4) * (75/25) = 12%.

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Jan 17, 2019

This is a good one too.

Jan 15, 2019

You're saying the same thing as above except its cap rate - int rate . Note the cap rate is the unlevered return of the asset assuming 0 growth. This is Modigliani Miller proposition II in its simplest form (without taking into account taxes and cost of financial distress as you increase leverage). Note this is a gross estimation since D/E is constantly changing with amortizing/term loans and is not static throughout the life of the holding period of the asset.

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Jan 17, 2019

Just came up with another rather obvious one.

Debt yield = cap rate/LTV.

Just had an LP shitting on a deal with "5% debt yield" when cap rate is 6%. Not sure where he got that from.

Jan 17, 2019

He probably meant the levered Cash on Cash. I deal with this all the time. Some of the old guarde in RE are very frustrating to deal with since they don't use precision in these types of terms.

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Jan 15, 2019

Cap rate / debt yield = LTV so if your debt yield is 5 and cap rate is 6 -> a LTV of of 120%

Jan 17, 2019

Likely an obvious one, but your talking cap rate + Growth = unlevered IRR (assuming same exit cap).

Growth = average annual contractual rent escalation (let's say 3% per annum)?

Or

Growth = average annual rent growth?

Jan 23, 2019

Growth as in NOI growth. Rental rate growth can get muddy due to expenses. But if the expense ratio stays constant, rent growth would work too.

Jan 22, 2019

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.

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Jan 14, 2019

Here is another one:

Change in equity based on change in yield: delta (EK) = (yield1 - yield2)/(EK% x yield2). So, if the yield is 5 % today and 4 % tomorrow (ie. drop of 20 %, increase in property value of 25 %) and your LTV is 60%, the equity increases with 62.5 % = (5 % - 4 %)/(40% x 4%).

Jan 23, 2019

Thanks! By EK% in the denominator, do you mean % of equity? Or something else?

Jan 14, 2019

Yes, sorry, % of equity (ie. (1-LTV)).

Mar 3, 2019
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