What cash on cash would you accept for a low IRR?

Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes

I've been underwriting deals this week where cash on cash exceeds 12%, but the IRR on a 5 year old is around 10%. This would be an absolute triple net lease outpatient surgical center. For those who have invested (or thinking about investing in syndications), especially NNN triple net lease properties, what are your thoughts? I know it will be depend on lease length, tenant type, asset age, and location, but I'm curious how LP passive investors are navigating syndication are navigating investing in this environment.

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Matthew DrouinPro Member

Developer · Rochester, NY · Member since 2016 · 406 posts · 339 votes

@Neil Cronkrite why is the IRR lower than the COC? Usually it's the other way around. Are you expecting the cap rate to go up on an exit or refinance?

12% on a triple net outpatient surgical center seems pretty good. Medical office tenants are pretty sticky.

What's the duration on the current lease?

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Matthew DrouinPro Member
Developer · Rochester, NY · Member since 2016 · 406 posts · 339 votes
3y
@Neil Cronkrite why is the IRR lower than the COC? Usually it's the other way around. Are you expecting the cap rate to go up on an exit or refinance?
12% on a triple net outpatient surgical center seems pretty good. Medical office tenants are pretty sticky.
What's the duration on the current lease?
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Chris SeveneyBusiness Member
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Investor · VA · Member since 2015 · 21k+ posts · 19k+ votes
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@Neil Cronkrite
Are you exiting or refinancing at year 5? If so your exit would be bringing your IRR down.
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Neil Cronkrite
OP
Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes
3y
@Chris Seveney - Right now we'd be modeling an exit at year 5. Refinancing might work, but we first model a sale so we aren't specifically dependent on the debt markets.

@Matthew Drouin - Yes, modeling cap rate decompression. Usually starting at 10 basis points per year, sometimes more if we're buying below market cap and it's a heavier value-add. This is a sale lease back and the length would be 10 years.
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Matthew DrouinPro Member
Developer · Rochester, NY · Member since 2016 · 406 posts · 339 votes
3y
@Neil Cronkrite sounds like a great opportunity!
Podcast Guest on Show The $150K “Stolen” Rental Property and How to Avoid a Real Estate Scam
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John M.
Investor · Fairfax, VA · Member since 2015 · 1k+ posts · 801 votes
3y
Quote from @Matthew Drouin:

@Neil Cronkrite sounds like a great opportunity!

@Neil Cronkrite

is there any value add in this deal or is just a straight up flip after 5 years since you got it at a good price to begin with?
if your return on equity is 10% thats pretty good in my book. I assume the reason that its lower than 12% is that the bank is asking you to put a huge chunk down.
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Shafi Noss
Lender · Nationwide · Member since 2018 · 571 posts · 310 votes
3y
How can the IRR be lower than the CoC?
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
3y
I would invest in risk-free online savings, CDs, US Treasuries, and money market mutual funds at 5% over getting 10% in asset classes that have a risk component. The spread to risk-free is not sufficient (particularly given the magnitude of unprecedented government actions in recent years).
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Jason Merchey
Investor · Hendersonville, NC · Member since 2013 · 757 posts · 282 votes
3y
I too have gotten into 5% CDs and treasuries as a way to "barbell" my higher risk with apartments and other CRE. It's just too good of a return to ignore. In fact, if I were a few years from retirement, I would be very interested in a 10 year treasury note. Right now I need to aim for a higher average return than 5%, but 4-5% going into retirement is a great thing. It used to be that bonds were an important part of a typical portfolio--until bonds started returning near zero (which was pretty instrumental in pushing stock prices up as more dollars crowded into the stock market).

As to the OP, I am also wondering if the IRR can be lower than the COC--or if I am just uneducated as to how that could technically happen. I'm thinking if one were to simply drop out of a 5 year investment in year 4 without seeing a disposition (but having initial investment returned), perhaps the COC could be a little higher than the IRR because the IRR would be signaling that five years is a long time to get a return of capital...
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Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Shafi Noss:

How can the IRR be lower than the CoC?

Higher rent + little to no appreciation.
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Shafi Noss
Lender · Nationwide · Member since 2018 · 571 posts · 310 votes
3y
Quote from @Carlos Ptriawan:

Quote from @Shafi Noss:

How can the IRR be lower than the CoC?

Higher rent + little to no appreciation.

Then IRR should be equal to CoC. It's not mathematically possible for IRR to be lower than CoC.
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Bill B.
Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes
3y
You also can’t say this….”Refinancing might work, but we first model a sale so we aren't specifically dependent on the debt markets.”

The higher interest rates in the debt market will lower your sale price. The debt market could absolutely make selling a worse decision than refinancing. If you can’t afford to refinance and make the deal work then your buyer can’t afford to buy at that price.
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Ronald RohdePro Member
Attorney · Dallas, TX · Member since 2016 · 5k+ posts · 2k+ votes
3y
Quote from @Neil Cronkrite:

@Chris Seveney - Right now we'd be modeling an exit at year 5. Refinancing might work, but we first model a sale so we aren't specifically dependent on the debt markets.

@Matthew Drouin - Yes, modeling cap rate decompression. Usually starting at 10 basis points per year, sometimes more if we're buying below market cap and it's a heavier value-add. This is a sale lease back and the length would be 10 years.

still doesn't make sense to me. cap rates alone won't cause this. are you modeling declining market rents too?
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Neil Cronkrite
OP
Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes
3y
Quote from @Carlos Ptriawan:

Quote from @Shafi Noss:

How can the IRR be lower than the CoC?

Higher rent + little to no appreciation.

Exactly, great monthly cash flow without huge NOI bumps during the project period.
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Neil Cronkrite
OP
Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes
3y
Quote from @Bill B.:

You also can’t say this….”Refinancing might work, but we first model a sale so we aren't specifically dependent on the debt markets.”

The higher interest rates in the debt market will lower your sale price. The debt market could absolutely make selling a worse decision than refinancing. If you can’t afford to refinance and make the deal work then your buyer can’t afford to buy at that price.

The reason why we look to selling on our first pass is that there are fewer variables to predict or even manipulate. When model a sale, you simply model the exit cap. When you refinance, you also have to make assumptions on the interest rate, the LTV, AND the cap rate. As a sponsor, I could make a deal look sweeter if I fail to properly estimate any of those variables in the refinance estimate. Curious to to hear other thoughts out there.
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Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Neil Cronkrite:

Quote from @Carlos Ptriawan:

Quote from @Shafi Noss:

How can the IRR be lower than the CoC?

Higher rent + little to no appreciation.

Exactly, great monthly cash flow without huge NOI bumps during the project period.

pretty much like what I predicted. Getting 10% IRR is normal these days, so no question about IRR. If you can CF 12% that's great.
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Neil Cronkrite
OP
Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes
3y
Quote from @Mike Dymski:

I would invest in risk-free online savings, CDs, US Treasuries, and money market mutual funds at 5% over getting 10% in asset classes that have a risk component. The spread to risk-free is not sufficient (particularly given the magnitude of unprecedented government actions in recent years).

Thanks for your input. What do you mean by asset classes that have a risk component? Does that mean you have different investment criteria for different asset classes?
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Neil Cronkrite
OP
Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes
3y
Quote from @John M.:

Quote from @Matthew Drouin:

@Neil Cronkrite sounds like a great opportunity!

@Neil Cronkrite

is there any value add in this deal or is just a straight up flip after 5 years since you got it at a good price to begin with?
if your return on equity is 10% thats pretty good in my book. I assume the reason that its lower than 12% is that the bank is asking you to put a huge chunk down.

This would viewed as a core asset. The value add component would be annual rent bumps, but overall there isn't a vacancy to fill or lease to negotiate that would dramatically increase NOI during the hold period. We usually look to 70% LTV and 1.25 DSCR, but some banks can allow higher leverage at a higher debt service.
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Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Neil Cronkrite:

Quote from @John M.:

Quote from @Matthew Drouin:

@Neil Cronkrite sounds like a great opportunity!

@Neil Cronkrite

is there any value add in this deal or is just a straight up flip after 5 years since you got it at a good price to begin with?
if your return on equity is 10% thats pretty good in my book. I assume the reason that its lower than 12% is that the bank is asking you to put a huge chunk down.

This would viewed as a core asset. The value add component would be annual rent bumps, but overall there isn't a vacancy to fill or lease to negotiate that would dramatically increase NOI during the hold period. We usually look to 70% LTV and 1.25 DSCR, but some banks can allow higher leverage at a higher debt service.

For single tenant NNN the thing that you need to underwrite is the tenant main business operation, if they collapse you lose money with this deal. Ask their audited financial statement. But if you are LP I guess the GP co. already doing that. How much skin of the game the GP has in this deal ?
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Jay ThomasPro Member
Real Estate Agent · Houston, TX · Member since 2021 · 1k+ posts · 715 votes
3y
Real estate investors should be cautious, as the spread to risk-free is not sufficient compared to other asset classes that come with higher risks. While real estate has traditionally been viewed as a safe investment, in today's uncertain times it is important to maintain a diversified portfolio and weigh your options carefully before investing. Investors should consider allocating their funds into safer investments like online savings accounts, CDs, US Treasuries, and money market mutual funds, which offer a far greater return than the 5% spread to risk-free. By doing this, investors can ensure that their investments are secure and will provide them with a steady stream of income for years to come.
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
3y
Quote from @Neil Cronkrite:

Quote from @Mike Dymski:

I would invest in risk-free online savings, CDs, US Treasuries, and money market mutual funds at 5% over getting 10% in asset classes that have a risk component. The spread to risk-free is not sufficient (particularly given the magnitude of unprecedented government actions in recent years).

Thanks for your input. What do you mean by asset classes that have a risk component? Does that mean you have different investment criteria for different asset classes?

Absolutely...everyone has different investment criteria depending on risk and that's why asset classes trade at different values/cap rates. Government bonds and bank CDs have a dramatically different risk (and expected return) profile than real estate (or the stock market, crypto, commodities, etc.).
0 Reply
Carlos Ptriawan
Member since 2019 · 7k+ posts · 4k+ votes
3y
Quote from @Mike Dymski:

Quote from @Neil Cronkrite:

Quote from @Mike Dymski:

I would invest in risk-free online savings, CDs, US Treasuries, and money market mutual funds at 5% over getting 10% in asset classes that have a risk component. The spread to risk-free is not sufficient (particularly given the magnitude of unprecedented government actions in recent years).

Thanks for your input. What do you mean by asset classes that have a risk component? Does that mean you have different investment criteria for different asset classes?

Absolutely...everyone has different investment criteria depending on risk and that's why asset classes trade at different values/cap rates. Government bonds and bank CDs have a dramatically different risk (and expected return) profile than real estate (or the stock market, crypto, commodities, etc.).

The money being re-invested into Money Market flows in 2023 is like 5 times than average of 2010-2020, no doubt almost everyone is moving into fixed-income city.
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Mike Dymski
Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes
3y
Quote from @Carlos Ptriawan:

Quote from @Mike Dymski:

Quote from @Neil Cronkrite:

Quote from @Mike Dymski:

I would invest in risk-free online savings, CDs, US Treasuries, and money market mutual funds at 5% over getting 10% in asset classes that have a risk component. The spread to risk-free is not sufficient (particularly given the magnitude of unprecedented government actions in recent years).

Thanks for your input. What do you mean by asset classes that have a risk component? Does that mean you have different investment criteria for different asset classes?

Absolutely...everyone has different investment criteria depending on risk and that's why asset classes trade at different values/cap rates. Government bonds and bank CDs have a dramatically different risk (and expected return) profile than real estate (or the stock market, crypto, commodities, etc.).

The money being re-invested into Money Market flows in 2023 is like 5 times than average of 2010-2020, no doubt almost everyone is moving into fixed-income city.

Yep, and it was materially accelerated with the bank failures as business and consumers performed hygiene on their excess liquidity to ensure better returns and FDIC coverage. I actually moved money OUT of a money market mutual fund on the Monday after the SVB failure into a Wealthfront FDIC ensured cash account earning 4.8% (4.3% standard rate plus 0.5% referral bonus). At the time, there was uncertainty about the safety of money market mutual funds in the event of a bank failure but that has since been clarified.
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Neil Cronkrite
OP
Investor · Wheat Ridge, CO · Member since 2013 · 75 posts · 41 votes
3y
Quote from @Mike Dymski:

Quote from @Neil Cronkrite:

Quote from @Mike Dymski:

I would invest in risk-free online savings, CDs, US Treasuries, and money market mutual funds at 5% over getting 10% in asset classes that have a risk component. The spread to risk-free is not sufficient (particularly given the magnitude of unprecedented government actions in recent years).

Thanks for your input. What do you mean by asset classes that have a risk component? Does that mean you have different investment criteria for different asset classes?

Absolutely...everyone has different investment criteria depending on risk and that's why asset classes trade at different values/cap rates. Government bonds and bank CDs have a dramatically different risk (and expected return) profile than real estate (or the stock market, crypto, commodities, etc.).

I should have clarified, I meant commercial real estate asset classes. We aim as healthcare real estate syndicators mirror at lease what multifamily is modeling around 7% CoC and 13-15% IRR.
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Account Closed
Investor · Atlanta, GA · Member since 2017 · 174 posts · 104 votes
3y
It appears that either your exit year involves lease turnover or a significant outlier expense, which is distorting your IRR. A deal that generates such positive cash flows cannot have an unusually low IRR without a compelling explanation, even with a standard cap rate expansion assumption.

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Don SpaffordPro Member
Investor · Idaho Falls, ID · Member since 2016 · 935 posts · 629 votes
3y
Those issues in MF over the last few years are what led me into a different niche for Commercial RE. I invest in RV Resort Campgrounds. These properties deliver double digit cash on cash, averaging between 12-16% COC AND also get high IRR 20%+ on a 5 year hold. The immediate and high cash flows are what attracted me to this niche and I love it! I am always happy to share more information with those who are interested to learn more.
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