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Individual Rate of Return (IRR)
For most investors, IRR is the most important metric in multifamily investing. IRR alone can determine whether an asset is a viable offering to interested investors. Given the gravity of IRR, it’s important for operators and investors alike to understand which operational factors contribute the most to IRR. Craig Drummond – an acquisitions specialist at CREE Capital whom we consult when underwriting large deals, conducted an analysis to evaluate which operational factors IRR is most sensitive to. For this analysis, he applied a 10% increase to each factor below and measured how much the increase affected IRR. Among these factors are:
- Purchase Price
- Exit Cap
- Year 1 Gross Potential Rent
- Primary Loan Interest
- Vacancy (both physical and economic)
- Capital Expenditures budges
- Year 1 Rent Growth
- Primary Loan I/O (Interest Only)
By far Year 1 Gross Potential Rent had the most impact. This was shocking to us given the effect exit cap rates can have on re-sale value. However, taking a closer look the outcome makes sense. Year 1 GPR encapsulates the overall performance and drives the Net Operating Income, thus the value of the property. If the operating team is able to generate a high GPR in the first year then this trend is likely to continue throughout the hold period and result in higher cash flow and capital returns at the re-sale. Other notable factors were the purchase price and exit cap rate.
Cash on Cash (CoCo) Impact
Second, an analysis was conducted to determine which operational factors had the greatest effect on Cash-on-Cash return throughout the hold period. A 10% percent increase was applied to the same factors listed above. The results once again showed Gross Potential Rent as the most significant factors. However, the Cash on Cash proved to be more sensitive to the loan. Primary Loan-to-Value, Primary loan interest, and primary loan I/O proved to be have a significant. This makes sense because CoC is determined after expenses and mortgage payments. Lower interest rates and interest-only payments for a pre-determined number of months leave more room for cashflow to be paid out quarterly.
What Does this Mean for Investors
An investor interested in buying a share of multifamily property should pay close attention to the business plan. This means asking some of the harder questions.
Investors should be asking operators what the GPR is going to be after the first year and how they are going to make it happen. Specifically, pay attention to the renovation schedules. How many units are scheduled for renovation during the hold period and how many of these will be done in the first year? This is an important question because you rarely renovate with tenants in place. Therefore, the renovation plan will likely be dictated by current lease schedules because you will need to wait for them to expire before renovating. If the operators plan on renovating 50 out of 100 units and only 3 of the 50 units have leases ending that year, then GPR is unlikely to increase significantly in the first year. However, don’t fret too much because GPR will increase as planned in the second or third year.
The economic vacancy will also affect year one GPR. This is especially true in C-class markets. Part of the business plan may be to improve amenities thus inviting a better tenant base. If this is part of the business plan, you better believe there is an issue with the current renters which means unpaid or late rent aka “economic vacancies.” Getting bad renters out can have a significant impact on year one GPR because 1) you have to go through the eviction process which will take a number of months; 2) you will likely need to renovate the unit. In these scenarios, it’s not uncommon for vacancies to increase in the first year on an asset that was already struggling. Therefore, you would see a decrease in GPR and; therefore, a decrease in Net Operating Income.
Some investments simply require more patience than others. However, according to this analysis, if the property underperforms with a less desirable year one GPR, it will need to make up for it in the second and third years of the hold period.
Finally, what about the Cash on Cash Impact
It’s no surprise that the type of financing had a greater impact on Cash-on-Cash return than the IRR. This metric is only measuring the cash flow produced by the property. Net Operating Income is subtracted by the debt, before quarterly distributions. Therefore, less favorable financing will leave less cash flow for investors throughout the hold period. This is important to consider, especially if you are an investor hoping to get a consistent cash flow from your investment throughout the hold period.
Remember Cash on Cash only measures the cashflow during the hold period it does not consider capital events such as a sale or refinance. If you are directing your IRA into a property then maybe you are ok with a lower Cash on Cash value since your IRA is already a tax shelter you don’t need to put the depreciation against your cash flow. This makes a deal with less estimated Cash on Cash return, but higher IRR more appealing.
On the flip side, perhaps you are planning on putting the cash flow toward another investment before the end of the hold period. In this case, a higher Cash on Cash return would be a better option.
