IRR if holding forever / no "exit"
Hello,
Would appreciate someone's perspective of this. For the purpose of this exercise, the team is trying to model something where we do not exit / sell the property and hold on to it forever. It's a weird exercise but it's basically a program for affordable housing and the municipality wants to keep it forever.
I have the model running out for 20 years, paying down debt amortized at ~25 years and building up equity, but because there is no "sale" or terminal value the IRR is very low.
Now my question is, does it make sense to do an IRR at all or how would you appropriately assess the IRR in this scenario?
TIA
You have to "sell" it, because you have to somehow take the value creation into account.
So you would sell it in the model, but in reality you'd be saying, we bought for X, had X cash flow for 10 years (or whatever time period you choose), and between the cash flow and increase in value our IRR is X.
Yeah I think that's a fair take. The other thing I was thinking about was showing a refi at year 10, but I think what you're saying makes more sense for the purpose of IRR.
I work for an office that almost never sells. When I started two years ago, the partners did not like that my models had an exit after ten years and that I showed IRR, reversion value, and EMx.
Anyways, now I run the models out 20 years, show a refinance every 5 or 7 years depending on the balloon, and the only return metrics the partners like to see are cash-on-cash and developer yield.
Wow, that's really interesting. What would be considered a decent "developer yield?" I'm not too familiar with that metric
Also, does your 20 year time period include the time starting from acquisition to construction and completion? Or after stabilization?
Thanks!
I'm assuming they mean yield on cost, which is a common metric developers will use to measure the feasibility of a deal. Yield on cost is your NOI divided by the costs to develop (hard, soft and land). Typically you want to see a solid spread of 1.25-1.5 above market cap rates, so if your market cap rate is at 5% and your deal only yields a 5.5% there isn't much excess value created given the risks associated with development, so they won't do the deal, etc.
You could model out a 10 - 20 year hold and basically assume no reversion value, or reversion at the price you paid.
Yes, that's actually exactly what I have right now.
But intuitively it seems silly to think that the asset will have no reversion value after 10 or 20 years, the only way that would make sense is if you'd project eventual NOI to be 0 in which case you wouldn't invest at all in the first place
It's no different than holding onto a stock, you calculate your return in terms of both dividends (income) and share price appreciation. You don't have to sell the stock or property in order to do this.
You will still update the NAV of your properties and roll that up to your fund/REIT/portfolio NAV in the future, so the increase in property value will increase share price and price appreciation will still be included in your return, whether or not you sell or just hold and mark up the property. Basically the difference between realized and unrealized gains. I would still model it out as if you're selling in 3 to 10 years but maybe change the line that says "Sale Price" to "Reversionary Value"
That is a good way to look at it. Definitely helps. Thanks!
May be dumb but if you don’t want to sell it, can you not just look at what the yield on invested capital is? If that shows a super low return due to no sale then why own it without plans to sell?
Yes as another user pointed out you could look at cash-on-cash after doing a refi, which I have already built in.
Overall it is also low however the point of this exercise isn't to maximize profitability, it's a social program so the mandate is quite different!
For most companies, I would include the reversion value and calculate the IRR. If you have more old school principals (sounds like you do), you could run a return on equity calculation annually for the entire hold period and then take an average across the 20 year period. Personally, I would take an average over 5 year increments to analyze the return on equity over time as well. To do this, you can track property values in a different area of the model (calculate this annually) so it's not included in your projected cash flow. I would start by assuming some basic cap rate expansion each year for the 20 year hold period showing the properties value each year. You can then bifurcate the return from operating cash flow, debt paydown, and asset appreciation from the return on equity if you want brownie points.
How do you calc return of debt pay down/amortization? An example is putting on a hud loan which has long term (35 years) and amortizes. Cash flow will be lower and cash flow metrics are lower, but principal is paid down, and without a sale/reversion value the true value/returns are not fully captured with just cash flow metrics.
In this scenario I would add back the principal paydowns and do two return metrics
I agree the cash flow metrics won't pick this up. When I refer to return on equity (I understand others may define this differently) this requires you to factor in cash flow from the project, principal paydown on your loan, and asset appreciation/depreciation year-over-year. This concept is more commonly used in separate account deals for some private REITs. If they purchased legacy assets with a separate account client, they may never want to sell the asset. So instead of consistently showing them an interim IRR, they could calculate a return on equity metric that is broken down as follows:
(Cash Flow From Project + Principal Paydown + Asset Appreciation/Depreciation) / Total Equity Investment
For some groups, they will get third party appraisals for their mark-to-market exercises internally on a quarterly basis. Don't get me wrong, I think including the reversion value and calculating IRR's are the industry norm. However, I've seen separate accounts and some family offices use this metric for more long term legacy assets.
Thanks for the response. Just wondering, is it typical to assume cap rate expansion right now as a result of this market or due to building in a buffer of conservatism?
In general, most of the bigger groups I know are still factoring in some cap rate expansion to be conservative. I had an interesting call with a research team that noted they were advising their analyst to use a risk premium over the implied 10-year treasury forward curve. The risk premium is rarely consistent, but they are using that as a bench mark given the noise in the market right now. If you need a resource for a Implied 10-year treasury forward curve, you can check out Pensford's Forward Curve sheet => https://www.pensford.com/resources/forward-curve. This will vary greatly from shop to shop so you may want to discuss this internally with your principals after completing the modeling aspect of it.
Use two IRRs. Development (once project is complete & stabilized), then a cash-on-cash while its an IPP asset
We generally model indefinite holds as a 10-year cash flow (anything beyond that is so far beyond being able to even pretend to predict outcomes its not worth it) with theoretical sale at the end..
Seen some shops do 20.
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