A critical, yet less talked about component of underwriting is return pricing. Certain return metrics and hurdles must be used to determine an appropriate price to pay for an asset. For example, you may be an IRR driven investor and therefore will solve for a certain IRR such as 15% when pricing an asset. To think about it differently, you’re looking for a purchase price for the asset which projects a 15% IRR. Other investors may be cashflow focused and will determine the asset price by solving for a certain cash on cash number.
In this article, I want to attempt to share all the different ways we price assets based on the various deal profiles, financing scenarios, and return metrics. Starting with potentially the most important metric, IRR is a total return calculation which factors in the compounding time value of money. In our case, we focus on net IRR, which is the investor level return after all fees and promotes are paid – this is the return investors can expect to receive. The lowest net IRR we would be willing to accept is 12%. This lowest return hurdle is only for the best properties in the best locations, which potentially have more growth potential than what is factored into the numbers. Investors will not accept a 12% IRR unless it is for a newer vintage, high quality deal in a premier market. While 12% is the lowest return hurdle, our highest IRR hurdle these days is around 20%. We demand a 20% IRR for the riskiest of deals in smaller markets. By demanding such a high return, it forces to price the asset lower which helps create downside protection against the inherent risks of such an investment. Furthermore, it would be nonsensical to accept the same return for a risky, low-quality deal as a best-in-class deal.
In between 12 and 20%, there are many factors determining the appropriate IRR hurdle. For example, in my opinion, the largest source of risk for a real estate investment is the debt. If the exact same deal is purchased with a bridge loan instead of a lower risk permanent loan, the IRR hurdle should be anywhere from 2 to 4% higher because of the added leverage/risk. Some may feel this is an expensive premium to demand for an investment based on a bridge loan, but it really is the bare minimum since the added leverage of the bridge loan should magnify projected returns, helping close the IRR premium gap on its own. It is important to note that the IRR hurdle is important for every investment strategy while some of the metrics to be discussed ahead only apply to certain deal profiles.
The second metric we focus on is average cash on cash throughout the hold period. We typically seek an 8% minimum average cash on cash over a projected, five-year hold period. This hurdle may need to be pushed up or down depending on the quality of the asset and location. However, average cash on cash is only relevant for deals financed with permanent debt, since “buy it, fix it, sell it” business plans which include bridge loans are not meant to be cash flow focused investments. Nevertheless, the risk of investments backed by bridge loans can be gauged by the cash flow. For example, if year one cash flows are minimal or nonexistent, we will demand an IRR premium for such an investment.
Another factor contributing to risk and return premiums for cash flow are loan assumption deals. If a deal is a loan assumption with weak cash flows, we will typically demand a 300-basis point IRR premium. Investors love cash flow and need an enticing reason (higher IRR) to invest in a deal with weak cash flows. Even if the business plan risk profile of the deal is the same, the loan assumption contributes to a higher risk profile since a greater portion of the returns are based on a capital event in the future, rather than more certain, consistent, and sooner cash flows.
The third metric is amortized cash on cash return, which is the cash-on-cash percentage investors receive once a loan’s interest-only payments period expires and the borrower begins paying principal and interest. Amortized cash flow is an important metric to solve for since it protects the investment from being in a situation where cash flows become minimal after IO expires which increases risk as well as makes investors unhappy. Today, agency loans are typically offering three to four years of interest-only, so we look at the first year which amortized cash flows come into play and seek a minimum of 5% cash on cash (for the highest quality of deals). This requirement is often the constraining factor today when we are pricing opportunities. This is because interest rates are low which means IO cash flows are great but are materially lower once amortization kicks in since amortization makes up a greater portion of the total payment (or amortized debt constant) the lower the interest rate is.
The final but arguably most important metric is yield on cost, more precisely, un-trended stabilized yield on cost. Yield on cost equals the stabilized net operating income divided by purchase price plus capital expenditures (stab NOI / (price + CapEx)). Yield on cost is the purest form of valuation since it cannot be manipulated with growth factors, financing, or exit cap rate assumptions. Because of this, sophisticated investors love a true yield on cost calculation and allows them to cut through the noise to see an investment’s true value. We are looking for a minimum yield on cost of 5.5% but can demand as high as 7% depending on the market and risk profile of the deal.
Potentially the most important corollary to yield on cost is the spread between the projected yield on cost to market cap rates or the exit cap rate in the model. This spread indicates the true value creation driven by the business plan since the goal of the investment is to create a stream of cash flow at a cost basis which is less than what the market is willing to pay for that stream of cash flow. For a lower risk investment and a quality market, the minimum spread between yield on cost and our exit cap rate is 25 basis points. A deal which has a yield on cost which equals the exit cap rate can still project decent returns assuming strong rent growth in a top market.