IRR Is Not Your Friend

Your Flywheel Equity Newsletter is Changing…



I want to do something different with this newsletter than our previous format.

I want to provide more value to you as a real estate investor than a standard newsletter and give you insight you won't find from other operators.

I'll be doing this in a "Letter from the Founder" format this month.

Please let me know if you think I'm on the right track?

Letter from the Founder

I'm going to say something 90% of operators and capital raisers disagree with:

The IRR projections in any real estate deal are spurious and should be ignored.

Let's talk about why.

We've all seen multiple investor summaries for multifamily syndications. I am willing to bet most investors do some cursory review of the asset quality, its location, and then look at the overall return projects (most often represented as the IRR - internal rate of return).

I believe this is a flawed approach to investing.

Why? So much of the return projection relies on the valuation at sale which is a calculation that is hugely reliant on the exit cap rate and a variety of market conditions at some point far in the future (often 5+ years).

Do you know what interest rates will be in 5 years? Do you know what the market cap of that asset type is going to be in 5 years?

I sure as hell don't. So why would I make a determination of my investment based on an unknowable number?

Some operators do acknowledge this and provide a cap rate sensitivity in their analysis, which will show your returns dependent on a variety of exit cap rates.

But guess what? Most deals have a variability of returns between 10% and 20% IRR. What have you really learned about your investment from this range of outcomes?

Soooo, am I saying there is no way to judge the quality of a deal? Not at all. Just that any metric that relies on the exit valuation and, by extension, the exit cap rate is fundamentally flawed. Instead, as investors, we should focus on what is knowable today about the deal.

Here's a summary of what we know about a deal the day we close on it:

  • The current property performance
  • The debt terms
  • The renovation budget
  • Post-renovation rents using comparables from the market as it stands today
  • The current market valuation of similar assets (current market cap rate)

As investors we must be capable of evaluating a deal using these inputs as they are the most stable, knowable, variables to any deal.

Yes, even within these there will be variance. But we can be more confident in them as they are either known on day one of ownership or much more in our control than some broad market trend that is going to affect all assets equally, independent of the ownership group.

I'm not going to go into a lot of detail about these measurements here, but I believe the following are a far better representation of a deal than any future projection:

  • Unlevered yield on cost: This is the post-renovation yield of the property compared to the total purchase and rehab costs.
  • Amortized, stabilized, DSCR: This is the post-renovation, fully amortizing, debt service coverage ratio and is your margin of safety between the property's performance and your ability to make your loan payments.
  • Debt yield: This is the property's performance over the loan amount and is the best sense of how leveraged the property is.

These metrics capture several important factors in every real estate deal including 1) the property performance without the obfuscation of debt 2) the return on investment 3) the amount of leverage being used and 4) the impact of leverage on the financial outcomes.

These are all the factors you need to understand when making a real estate investment, not some IRR projection based on several high leverage but unknowable inputs.

As an operator it is my goal first to educate, and only then to provide investment opportunities to you. I am going into this level of detail because I want us all to be more sophisticated investors, and that requires a greater investment of time and education.

These measurements are essential in truly understanding the risk/reward profile of your next investment and can be calculated from almost any investor packet.

If you are interested in learning more about these metrics and how to apply them, let me know by replying to this email. Your feedback will determine if I continue with this format in the monthly newsletter.

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