Rough mental return calculations?

g0ttag0's picture
Rank: Senior Monkey | banana points 82

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!

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Comments (12)

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 14, 2019

This is helpful, thank you. So adding on to the original scenario above with a 5% cap + 3% growth: If the deal were 50% LTV with a 2% (interest only?) loan, that would imply a levered IRR of 14%, right? 8% [UL IRR] + (8-2)*(1/1) = 8+6 = 14?

Do you know of any approximations to adjust for exit cap rate expansion or compression vs. entry?

Jan 14, 2019

That is correct. Please note that this only holds for shorter periods. As the GRI grows with G, the D/E decreases all else equal (constant yield, etc.). You would thus have to adjust the IRR down as the holding period increases. Yes, interest only. With amortization, the D/E changes, so you would have to take that into account when approximating.

Not that I know of. I would think that is more than rough mental return calculation. For instance, if the cap rate compresses from 5 % to 4 %, the property value increases with 25 % - all else equal. The IRR will be heavily affected if this happens in year 1 or 2, less so if it is in year 25. Somethings are just easier in Excel but you could obviously get a feel for it with some experience.

Jan 14, 2019

Go with this one. It's always a little off say maybe 20-30 bps but it's very close

Jan 15, 2019

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

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%.

Jan 15, 2019