Which should have the highest IRR: Office Building, Multifamily apartments, or retail shopping center? Why?
I've gotten this one in a few interviews and because of my limited real estate experience I think I have been getting it off. Last time I said highest would be shopping center (22%-25% IRR)because you dictate the tenant mix which will help your clients want to resign. Also because you can charge some percentage rent based off sales. Second would be multifamily(around 22% IRR) , because you can bring in some ancillary income and people have a decent chance of resigning if you keep them happy. Last would be office building (around 17-20% iRR) and I don't even remember the reasoning I gave.
What do you all think it should be? Obviously these are subjective, but I was wondering you guys could help me out in case I hear this one again. Thanks
Highly dependent upon the market, but in most major markets development IRRs are in the low double/high single digits (8-12%) for most property types. Now, single-family residential development IRRs are closer to the 20-25% range. If you're developing a NYC apartment building then you're probably in the 7-8% range (give or take, of course--I'm no NYC expert).
Again, the market is going to dictate which property types will have higher IRRs. Class A office in the District of Columbia is killing it. A new office building away from the metro in Northern Virginia just sucks right now and probably wouldn't get built without an IRR in the 10+% range. So I would say your question is impossible to answer as it is entirely market dependent.
Thanks for your help. I agree it is completely market dependent. I don't think they care if the IRR is exactly right, I think they just want good reasoning as to why one would be higher than another
Good reasoning is the balance between supply and demand.
You're talking development. The question was which asset class in general. Multi-family and Class A towers will always be at a lower cap---and if you're not developing it, a lower IRR.
It's all relative, you can't simply say "Multi-family is the best cause it has a lower cap rate" cause you'd also be buying at a lower cap, meaning that you'd need to underwrite your deal based on cap rate compression which is a giant no-no IMO. You aren't ever going to nail down the capital markets side so it needs to be based on projected income growth if you were to really answer this question.
I have a different opinion. For me: The higher the risk, the higher my IRR should be (risk return)
So the lowest risk is with the multifamily. Why? Everyone needs to live somewhere. Additionally, "multifamily" makes it even less risky because we do not have a large single tenant risk. Medium risk is with the office building. An office building might not be a basic need (other than a house to live). (Better arguments anyone why office in general is more risky than residential?) Highest risk is with shopping center: Highly specialized asset class. Risk of getting enough tenants, having enough frequency in the mall, having a large enough catchment area, etc.).
Tl,dr: From low IRR to high IRR: residential -> office -> shopping center
What IRR ranges would you give each? Residential somewhere 4-6%, office: 6-9%, shopping center: 9-12% ? I just have not seen IRRs frequently as I am on the financing side of things.
I just don't think one can make this kind of assessment. The law of supply and demand generally drives riskiness, not the inherent asset type or even asset class.
Multifamily is always in demand, but incremental multifamily is not always in demand. It depends on the level of supply and demand. Multifamily is less volatile than office and retail because office and retail generally follow the economic cycle (this probably impacts cap rate more than IRR), but for development purposes, an area over supplied with multifamily and under supplied with retail will likely show lower IRRs for retail developments.
Agreed
Mott pretty much covered it. IRR should follow risk, lower IRR lower risk, higher IRR higher risk. In an urban, entry market, it will go Apartment, Retail, Office (lowest IRR to highest). Notice I said retail instead of shopping center.
If we're talking about shopping centers in particular then its most likely a suburban market. In suburban markets I would bet shopping center and office IRR's flip depending on the affluence of the market. For example in Northern NJ shopping centers are relatively safe due to the wealth in many of those counties and the suburban office sector is getting hammered there. On the other hand markets like Charlotte or Raleigh have higher demand for office than most suburban counter parts while their shopping/power centers have been in a slump like a lot of America due to e-commerce competition.
I hate to use this (but I seem to use it every thread where people ask questions like this) but it depends on the market. In an extreme example; in markets like Phoenix I would not be surprised to hear of an apartment complex require a higher IRR than an established shopping center.
Also to throw you another loop, in good retail markets (median household income above 100K with 100K+ pop. in a 3 mile radius) cap rates for grocery anchored retail are at or below industrial.
Agree with Mott and SHB. There are too many variables and obviously everything is market dependent. However if you are looking for a generic answer my person opinion for lowest IRR to highest would be.....
Multi-Family, Industrial, Office and Retail
I don't understand how I can keep getting monkey-shitted when I'm objectively correct.
There's no such thing as a linear, unchangeable chart that describes the riskiness of real estate asset types for development. Even for shopping centers, development may not be that risky if you've got a 15-year pre-lease from a Whole Foods in hand plus full occupancy of retail supply and obvious demand/obvious under supply. The answer to the OP's question is that it depends.
Retail is more tricky, there are more questions, do you have good anchor tenants, is your tenant mix strong, are tenants good credit. Yes a 15 Year Whole foods deal could happen, but that cap rate would be really low. As a developer you could see strong IRR moving a whole foods tenant in, rather than building anything.
Isn't this more of a cap rate question than IRR? Fundamentally, core multifamily cap rates are less volatile, even paying a 4% cap rate for new construction in a market like Seattle or Boston, you may very well be in a position 10 years from now to be able to sell at a similar exit cap. Buying office, your potential cap rate at exit could be materially higher than your cap rate at purchase today, irrespective of your occupancy %, NOI, etc.
In terms of being compensated for the risk, yes I would concur that in general, ground up apartment developers are building to a lower yield on cost than retail developers. In office, it is still dicey to build spec, although in some markets (i.e. the SF Bay Area), I am seeing major developers moving forward with spec office and banks are getting more comfortable financing these. If you can build to suit or have a major tenant in tow for a new development, then obviously you can build to a lower YOC because you have higher certainty in your stabilized income/NOI.
Exactly. This isn't really a question of IRR; it's a question of cap rate. Cap rate is essentially a PUBLIC, external market's measure of risk for stabilized properties. Since office and retail track more closely with the economic cycle those asset types will usually have higher cap rates to compensate for the risk.
When it comes to development, the balance between supply and demand--and holding period--in individual markets will dictate a developer/investor's risk tolerance for a particular asset development, which is measured internally by IRR. IRR will vary radically depending upon the relative balance between supply and demand in the specific Subject market.
With stabilized product its the same thing, lower cap rate, lower IRR, lower risk, lower return. But when the asset is not stabilized you can't confuse cap rates with return or risk. With opportunistic investing you would be buying buildings at a 1 cap with the assumption of greatly increasing income and getting a huge IRR. In that example a low cap rate =/= low IRR or low risk.
I think his point (at least what I gathered, because I agree) is that what people here are trying to do--lay out a clean and neat chart about which property types are least risky to most risky--is really only valid with stabilized properties, hence looking at cap rates for various asset types. The reality with development is that there is no way of laying out a clean and neat chart for risk levels of different property types because it will depend on a lot of factors. To say that a multifamily development opportunity necessarily carries a lower IRR (which can be an entirely subjective measure from an investor) than any other property type is simply not correct. The multifamily development is not necessarily a lower investment risk than any other property type--it will just depend.
"Multifamily --> retail --> office" is simply not a valid way of laying out risk with regard to non-stabilized properties, although it's generally valid with stabilized properties (with exceptions, of course).
And I keep getting monkey-shitted by anonymous people who can't back up their position.
i believe the correct spelling is "monkey shat"
I'm guessing its those brokers who are still butthurt about your comments a few weeks ago
You are being monkey shat for complaining about being monkey shat.
The more opportunistic the higher the targeted IRR ie. risk/reward. Not sure if this question is a smoke screen to get you to say something stupid. Asset classes change, regarding their attractiveness, throughout every RE cycle. Also depends upon what type of asset you're talking about, class A, class B? What't the strategy? Is it a value-add deal? A core deal? Is it a new development? Also, like someone else said, what market is this in?
I think this question is best answered by following up with additional questions.
There are a lot of factors at play here; too many to provide a good answer without additional clarification.
Real estate fundamentals and conditions between commercial and residential vary dramatically based on geographic location. Beyond that, we're not told about the relative size of the three types of investments. How many family's in the apartments? How many floors in the office building? How many shops in the shopping center? A two family house and a 30 family apartment building face dramatically different conditions and risks.
The thirty family apartment has a higher degree of commercial diversification (assuming that it's located in an area with a wide array of employment opportunities) and is more fungible, i.e., each individual tenant accounts for only a small portion of revenue (lower degree of customer concentration risk). This is true for all three types of investments. A shopping center with one primary customer is more risky than one with many, commercially diversified customers.
If we hold all other things constant, i.e., assume that all three have the same level of idiosyncratic risk, then we have to determine which one has the highest degree of market risk. Presumably, the macroeconomic conditions that would put stress on a shopping center should put the same sort of stress on an office building. And, again presumably, the result of failing businesses would be higher rates of unemployment which should should make it more difficult for individuals to pay their residential rent.
The only factor at play here is the effect of e-commerce adding an additional layer of risk/competition for the commercial shopping center. That's the only fundamental difference driving its higher required rate of return.
At the risk of sounding like a patronising dick, if you mentioned 20%+ IRRs and did not make it clear that you were talking about development then your answer is just wrong. Buy and hold does not get you 20%. Most value add does not get you 20%.
If the question is regarding buy and hold, you could answer the question pretty clearly. A good shortcut is that pre fund fee and pre debt IRRs are roughly cap rate plus growth assumption. Know your cap rates for your patch and add a few points for rent growth and strategic asset mgmt.
For value add and opportunistic, IRR is 100% project specific. The target IRR should be set at a level based on its variability, ie risk adjusted. If the st dev of returns is low then the target can be low etc. Asset class is largely irrelevant for these deals.
Id would just add that you also have to consider not only the market risk, but the deal-specific factors of the investments (current vacancy, major tenant roll, capital projects), which all affect the risk and therefore the return profile of the investment. Esuric touched on that a little.
For the OP, the interviewer really wants to hear your thought process more than anything. Not necessarily a 'right' answer.
IRR is at its simplest a function of the size and timing of cash flows, and there in lies your answer.
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