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Reinvesting Cash Flows To Maximize Returns
January 19, 2020
Many of the syndicated multifamily investments I come across pre-raise the full capital expenditures budget either through equity or through a lender-financed budget. Today, I’d like to explore the idea of reinvesting cash flows back into the property as a valid strategy to increase total returns. Pre-raising the capex budget is the prevailing protocol, especially in the syndication space because limited partners like to see higher, more dependable free cash flows. Additionally, some sponsors pre-raise funds for the sole purpose of distributing those funds as cash flows to increase first year returns, which typically lag in a value-add investment. However, both pre-raising capex and raising funds for distribution (which is technically incorrect) create a long-lasting drag on future cash flows and total returns. Sponsors mostly do this because they are trying to manage the expectations of investors and deals with higher cash on cash are easier to sell.
Pre-raising capital adds to the total cash outlay, which is the denominator used to calculate cash on cash and total annualized returns. The alternative is to not distribute free cash flow to investors but rather use cash flows to finance the renovation budget which would lower the cash on cash returns for a given year but would increase the projected IRR because the total investment is more capital-efficient. Brian Murray, in his Amazon best seller Crushing It in Apartments, strongly advocates reinvesting the profits from apartment investing right back into the property to drive NOI. Murray is in a better position to control the distribution of profits because he invests mainly with his own capital, thus giving him the freedom to not be beholden to a preferred return distribution to LPs.
Depending on the business plan, it may make sense to pre-raise a sizable portion of the capex budget in order to quickly take care of pressing deferred maintenance or interior renovations. However, there are often capex items found in a budget that can easily be done over the course of three to five years and thus could be financed out of operational cash flow. Even for syndicators paying out a preferred return, it may make sense to model out this approach since the larger the equity raise, the higher the preferred return is in dollar terms. This means an increase in pre-raised capex budget results in a direct increase in the preferred return obligation of the sponsor (again, in dollar terms), which of course, makes it more difficult for the sponsor to achieve the preferred return and collect his or her promote. While choosing to not pre-raise for the budgeted capex item doesn’t mean the cost magically disappears; it still must be paid out of operations. This below-the-line expense (non-operating expense) could possibly still result in higher cash on cash returns if the expense is amortized over a long enough period of time and isn’t a really big-ticket item.
In essence, pre-raising a modest capex budget, which could otherwise be financed from operational cash flow, trades higher first year (and potentially second year) returns for lower overall returns due to the drag of increased principal cash outlay. On the flip side, using cash flow from operations for capex is more capital efficient and results in higher total returns (IRR) but can significantly reduce annual cash yields. This trade-off is similar to the issue of “short-termism” prevalent in business today. Warren Buffet has been a long-time advocate of doing away with quarterly earnings projections as it forces managements to act in the short-term interest of the company to meet quarterly numbers, often to the detriment of the long-term success of the business. Here is a recent CNBC interview with Warren Buffet and Jamie Dimon discussing “short-termism” and the power of thinking long-term.
I don’t think completely avoiding pre-raising any on non-operational expenses is a reasonable approach for most value-add investments. Additionally, less sophisticated LPs or LPs looking to live off of the income produced from the investment may find much lower initial distributions intolerable. However, trimming capex budgets where possible and judiciously looking at the opportunity to spend capex down the line via cash flows is a superior strategy. For sponsors, this may mean educating their LPs on this subject and getting them comfortable with the higher returns possible when forgoing meaningful returns for the first year or so.
To illustrate this point, I will use an example deal, model several scenarios, and compare the projected returns:
Example Deal: The numbers I’m using for the purposes of this exercise are largely made up but are based around the real numbers of a recently underwritten transaction.
Note: Returns are project level so as to not obfuscate the returns by the fee structure and how it varies based on the different performances of the investment strategies.
Scenario 1: Pre-raise full $2,000,000 capex budget.
Example $100,000 Investment
Scenario 2: Finance all capex out of cash flow. We assume we will spend $750,000 for year one, $500,000 for year two, and $500,000 for year three, and $250,000 for year four.
Example $100,000 Investment
As you can see the IRR for scenario 2 is 200 basis points higher because the investment essentially requires $2,000,000 less in upfront investment to achieve the same performance. Now, more analytical people may be quick to point out that the longer timeline in scenario 2 for spending the full $2,000,000 budget should also reflect in more conservative NOI growth assumptions. This is absolutely true, but for the purposes of this example, I will assume there is no difference (we DO consider this and take it into account when putting together our business plans). Let’s take a deeper look into these returns.
As you can see, the cash flows are significantly lower in scenario 2, especially for the early years, simply because we are plowing cash flow back into the property. However, year four shows us that even though $250,000 (nearly 20% of cash flow after debt service) is spent on capex, there is still a 13.2% return available for distribution (10 basis points higher than scenario 1). Furthermore, once the capex budget is spent, year five shows the power of scenario 2’s strategy by showing 17.6% projected returns. This is significantly higher than scenario 1’s year five cash on cash. Even more compelling, the profit upon sale is substantially higher in scenario 2. The difference lies in the $2,000,000 lower basis for which the property was purchased and operated with, resulting in $2,000,000 less of the sale price allocated to repaying principal and more towards profit. Again, while not having any pre-raised budget may not be realistic, this example should illuminate the benefits of deferring some of the capex budget and finance it out of operations.
Another important element to mention is how these two scenarios play out in a syndication structure for LPs and GPs. The book Investing in Real Estate Private Equity spends a good amount of time discussing alignments of interest, a common refrain in private equity, and poking holes in some of the typical alignments of interest and how they actually may push sponsors to take risks against the LPs’ best interests. If a syndication structure has a cumulative 8% preferred return, a sponsor would be crazy to run with scenario 2’s business plan because they would never hit the cumulative pref, forgoing collecting any promote compensation. This is an example where a standard alignment of interest, the preferred return, actually incentivizes GPs to think short-term rather than optimizing the business plan for total returns. I’m sure sponsors could devise a modified structure which would still allow them to get paid their fair share. Even if the sponsors of this hypothetical investment decided not to modify the typical GP compensation structure, they still might come out ahead due to the increased compensation upon sale due to the lower basis in scenario 2. For example, applying a 30% profit split to the GP in scenario 1, the GP would earn $1,694,713 of the profits on sale. In scenario 2, the GP would make $2,294,713. That’s more than a 35% increase in profits! In summary, assuming a 2% acquisition fee, 2% asset management fee, 8% preferred return, and 30% profit split, the GP would come out ahead in total dollar terms in scenario 2. However, the increase is coming from the back-end sale, which carries more uncertainty and is of course further out in time than on-going promoted cash flows. I took the five-year projected GP profits for both scenarios and discounted them back at a 10% discount rate to compare the net present value of the GP profits for both scenarios. One could argue this discount rate should be higher but I’ll leave that discussion for another time. In conclusion, scenario 2’s NPV of the GP compensation is 5.4% higher than scenario 1. These higher profits are achieved without even negotiating a more reasonable split with LPs since the promote didn’t even come into play on the cash flows in scenario 2.
This study is a classic discussion of highest and best use of capital. Managements of businesses and investments understand the various uses of free cash flow (reinvestment, acquisition, distribution, and stock repurchase). Businesses which have high growth potential should not have a dividend and should spend aggressively on capex. Meanwhile, more stable and mature companies may actually provide the greatest benefit to their shareholders if management simply distributes free cash flow via a dividend. Further thought could be put into what the potential discount rate is for these hypothetical shareholders. By discount rate, I mean the opportunity cost shareholders bear for forgoing free cash flow and instead see cash flow reinvested back into the business. For example, if shareholders can readily achieve an 8% return in an external investment with comparable risk, then the return on reinvesting cash flows of the company must be greater than 8% in order to do so. Aswath Damodaran, professor of finance at NYU, beautifully explains some of these ideas in his valuation series on YouTube.
Bringing the discussion back to multifamily. The potential returns available from reinvesting back into value-add apartments are tremendous. A classic example is the purchase of washers and dryers. If the units of an apartment community already have washer and dryer connections then the cost of the machines and installation is relatively low. Let’s say it costs $1,000 to put in fairly nice washers and dryers and the upcharge in rents is a modest $40. This investment would result in a 48% annual return on investment (ignoring the increase in operating expenses associated with washers and dryers in units). I don’t think anyone’s discount rate is anywhere near that so it would make sense to invest in this capex project versus distributing available cash. Other high-return investments for multifamily are valet trash, interior renovations, RUBS, LED lighting, reserved parking, and storage units.
To wrap up, it is important to always consider what the highest and best use of capital is in any given situation, especially on a risk-adjusted basis. Investors may have a hard time accepting lower cash on cash returns and instead, prefer capex budgets to be raised upfront (this also lowers the risk of a cash crunch or capital call). However, investors pursuing total returns will find that reinvesting cash flows into capex is one of the most effective uses of capital and should consider other asset classes allocations of their portfolio pursuing yield. For example, mobile home parks are a stable business, display recession-resistant qualities, require less on-going capex, and typically have higher cap rates. This means lower growth and higher yields. ATMs are also another asset class that have tremendous cash on cash potential but less-than-spectacular IRRs (total returns).