IRR is a great metric to pitch! What about when not selling

20 Replies

Hi everyone! When I’m underwriting a deal and there is a sale involved, there is no doubt that IRR is one of the best metrics to use and to give your potential investors. However, my model is to buy, refinance, and hold into perpetuity. In the future I may sell if the opportunity arises but it’s not in the business plan. Without a sale, IRR sort of breaks down. So to substitute IRR, all I’m left with is an average annual return or an average cash on cash return over say 10 years (because I have to define some time period) to show investors what they’ll make. Every syndication example that I’ve seen has had a sale at some point in the model (usually 5-10 years). Thus an IRR was able to be calculated. I’m wondering what people suggest if you dont plan on sellIng as far as marketing your deal to investors. How does a conversation like that go? What numbers would they be interested in since IRR is off the table now. If anyone has experience or suggestions I would appreciate it! Thanks in advance

@Marc Izquierdo will your investors want to stay in the deal with you for 10+ years? 

My guess would be no as most investors are looking for 5 year deals. However you might have a different investor mix.

I assume the investor shares in the refi proceeds, that will help your IRR.

The reason that every syndication example that you've seen has a sale at some point is because the first question that your investors will ask you when considering your deal is "when will I get my money back?".  "Never" is not a good answer, and any deal structured that way is unlikely to get funded--so all of the offerings you see are structured for a defined period of time. Legacy-style holdings are for your own capital.  A lot of family offices will do this--they'll just own the asset for generations.  But they don't do that with a syndicator, they'll own it directly.

Perhaps you have investors with a different appetite, but I can tell you that after having raised over $80 million I couldn't get a deal done for even a minuscule $1 million raise if I didn't have at least some type of exit plan.  In the mind of most investors, a refinance isn't an exit plan.  It can give a return of some capital, and at some point you might be able to refinance again and return the rest, and in rare instances even more, but the investor is still in the deal.  Investors looking for that type of deal are few and far between.

Another reason that you don't see forecasts in perpetuity is that they are meaningless.  No one can predict what rent growth will be 20 years from now.  And how do you factor in capital improvements?  Do you refinance and take out cash to pay for a new roof when it's due?  Or to upgrade the units all over again in 10 years?  All of those unpredictable variables would have to go into an analysis that stretches out that far and no one will get that right--rendering the numbers useless.  This means that your investors have no way to grade you.  Are you outperforming, under-performing, or right on target?  No one would know.  And then what happens when your investors start to die off?  Now you are dealing with their heirs, who are stuck in an investment they didn't choose to be in and start suing to force a sale...ugh!

Having said all of that...if you are going to do to this all you have to go on is maybe showing a cash-on-cash return for each year for the first few years and saying that after that your investors just have to rely on blind faith that this is still the best investment for them, because it will be impossible to quantify it to them in advance.

@Brian Adams

The length of the investment was one of my thoughts and whether or not someone would want to keep their money tied up.  But suppose investors were ok with receiving cash flow for the rest of their lives (that is what I want at least!) - maybe I’m being unrealistic of what investors want though (still new to this)

Exactly, the investors have equity and therefore enjoy the proceeds. And just like you said, that'll increase their return but not IRR because there is no sale. That is where I struggle. You can get investor cash on cash returns up to 20%+ after a refi.

@Brian Burke

What a great answer!  That is exactly what I was looking for.  It makes complete sense.  

Since I want legacy type investments for myself, that’s exactly what I’ll do...but for myself!  I’ll grow my business (using investor capital) to fund that but again, on my own.

Again, awesome explanation.  Thanks!

Marc,

Part of the reason is as @Brian Adams and @Brian Burke mentioned, but there is also Estates to worry about, holding on to a property until your relatives inherit it is one thing ( the basis for the property is what the property is worth when you pass) and great if you completely own it but to investors, this does not help them, they would have to pay their share of capitol gains when the property is sold no matter what. there is also a point in time where a properties worth actually starts to cost you money, mainly because depreciation and the cost of the recapture tax starts to reverse the profit numbers if the property does not appreciate enough in value.

@Marc Izquierdo Even with what @Brian Burke said, you can still have your legacy investment model, AND have an IRR based exit plan for your investors, by offering to buy them out after the refi. This will allow them to get their original investment back, with a return, and allow you to retain the entire equity after refi. The exact structure would need to work for everyone, so it could be a win-win, and might not be as spectacular returns as with a sale, but the numbers could still work for investors.

@Patrick Liska Yea the estates are good point.  I wasn’t aware of the fact that investors will still pay the full capital gains tax even after the cost basis of the property has changed (after inheritance).  Interesting.  The depreciation and recapture is interesting .  How does recapture come into the equation with investors?  After you sell, does anyone with equity in the property owe recapture tax?  I’m now interested in how the end of a syndication works since everyone with equity may not want to 1031 into something else.  

@Yonah Weiss Yea I was also considering that strategy of a buy out at some point. I guess that strategy would require a refinance probably later in the projects life (maybe 7-10 years?) where you could return their original capital plus buy them out of their equity stake. For example, consider a scenario where you bought a property at 500k (300 debt and 200 equity) with an investor funding 100k (you the other 100k) and both of you splitting equity 50/50. 8 years from now the property is worth 1M. So at the end of the project, you refinance and take 800k (80% LTV - that's optimistic but for example purposes), the investor is entitled to 50% of the value of the building at that point so you owe them 500k, plus the 100k they originally invested. Then have enough to pay the outstanding loan balance. Hopefully 800k would cover that. I guess you could play with the numbers during underwriting to see when the beatbox time to to refinance would be be. Interesting to think about.

@Marc Izquierdo No exit plan will make it hard to attract investors, lenders and other partners. Your investors might tell you one thing now ("I'm a long-term buy-and-hold investor") but reality is going to be very different as life situations, relationships and demands take a toll. 

You can play with #s all you like but unless you have a solid track record and/or significant personal capital, it will become very hard to do a related-party transaction and not annoy most, if not, all of your investors (regardless of what they are saying now). This is because you have a massive conflict of interest. In other words, investors will always be suspicious when you decided to sell to yourself or a related party.

@Omar Khan

Ok so you’re saying investors would see it negatively if I said to them that in 8 years, I return your initial capital and buy you out of your equity for a return of XX% overall?

Originally posted by @Marc Izquierdo :

@Omar Khan

Ok so you’re saying investors would see it negatively if I said to them that in 8 years, I return your initial capital and buy you out of your equity for a return of XX% overall?

I can't speak on behalf of your investors. My point was that people change their opinions especially when it comes to related party transactions. You are not planning for right now but for the future. The more loose ends you have the more, potential, hassle you will have to deal with. 

Even with sophisticated/institutional investors, it becomes a hassle managing the political dynamics around related party transactions. Btw, this is not a critique on your proposed structure, your as an investor or the veracity of this strategy. This is purely an analysis based on how people actually react years down the road as opposed to what they are saying right now. 

Originally posted by @Marc Izquierdo :

@Omar Khan

Ok so you’re saying investors would see it negatively if I said to them that in 8 years, I return your initial capital and buy you out of your equity for a return of XX% overall?

@Omar Khan won't speak for your investors, Mark, but I will.  They will not look favorably on you buying them out and keeping the property for yourself.  Plain and simple...investors don't like that sort of stuff.  You make money when they make money and everybody is in this together all the way to the end.

My sense is that you are approaching this all wrong.  You are looking at this as one opportunity to get investors to buy one property and trying to make a lifetime investment out of it.  My advice:  stop thinking that way.

Instead, you want to get your investors in this deal and get them out as quickly as you can.  Not so you can keep it for yourself, but so that you can make them a great return.

So to that you say, "ok, now what?"  Well, the answer is this:  Those very investors will think you are amazing because you got them a great return.  And, they also have more money in their pocket than when they started.  Two things will happen.  First, they'll invest in your next deal.  And they'll invest more than they did the first time.  Or they'll invest in more than one deal.  The second thing is that they'll tell their friends about it, and your phone will start to ring from new investors.

Instead of buying one property and holding on forever, you can now buy many properties, of increasing size over time, and build exponentially more wealth and cash flow for both you and for your investors by abandoning this legacy holding idea and focus on building a track record of full-cycle performance.  Rinse and repeat.

That's my $.02.  :)

@Brian Burke  

That absolutely makes sense.  Yea I definitely believe I was approaching it wrong but your advice has helped shift my mind.  I really appreciate it.  The information is invaluable!

Marc,

I have not tried to raise funds and maybe others can fill you in on how they set it up with investors but i would think that most lenders have it as a loan and want 1st lien on the property, if they own title to the property then they would claim their percentage of the depreciation and would have to pay their percentage of the recapture tax when the property is sold. as far as the 1031, that's beyond my knowledge maybe @Dave Foster can help on that.

I know several investors that purchase with no exit in mind to their investors. Their goal is to buy, cash flow, add value and refi, eventually returning all capital to the investors. Their main metric is cash on cash return. The next metric is return on capital based on projected refinance time frames. These sponsors are very successful and one in particular has been doing it since the 1980's. 

@Patrick Liska Yea that makes sense to me all the way up to the 1031.  It sort of sucks that investors wouldn’t be able to escape the recapture tax.  Maybe they can though?  I’ll keep poking around to see if I can get an answer to that

@Todd Dexheimer Very interesting.  I’d love to talk to them.  Would you be able to connect me with them to ask some questions? 

@Marc Izquierdo  This is an excellent exchange.  I learned a lot.  So it sounds like your goals of buying and holding for passive income conflict with the syndication model.   Maybe the best path for you is to participate in larger deals with partners that have similar goals, rather than syndication. These wouldn't be as large as most syndication deals, but a great start.  If the deal is over a certain amount (maybe $1.5mil) Fanny and Freddy underwrite loans that won't require refinancing after 5 years.   Good stuff 

@Marc Izquierdo , There are only two  ways a syndication works with 1031 exchanges.  The first is if the investors are all on the deed of the property as tenants in common.  Then when the property sells each investor can 1031 or not their own ownership interest.  As @Patrick Liska mentioned this rarely works with financing because lenders do not like the mess of multiple small investors and want to be in first position etc etc.

The other way that 1031 works is if the parent syndicator (LLC or LP) wants to sell and do a 1031 exchange of the whole. I've seen this but most syndications have trouble timing so that they have the next perfect deal lined up in time to meet the 1031 calendar. And the issue of investors not wanting to go along with the parent and how to pay them out to buy their interests and also 1031 is problematic.

Hi Marc,

As others have said on this thread, you are limiting the number of investors you will attract if you do not plan on selling the property. But, I know there are passive investors out there who are interested in longer-term projects.

You have a few options:

  1. Simply offer the CoC return projections for the 5 to 10 years in the future
  2. Underwrite in a refinance in 5 to 10 years, ideally returning your investors' initial capital plus additional profits (but it has to be the right deal to receive such a massive lump sum after a refinance)
  3. Consider changing your investment strategy to include a sale at some point in the future

At the end of the day, the most important return factor depends on the investor. I would start having conversations with potential investors and for those who are interested in investing in a deal without a sales date, ask them what type of returns they want to see.

@Marc Izquierdo Why don't you just look for debt investors? That ways you can refi out of the deal and cashout the investors and keep the property in perpetuity for yourself. I honestly don't think IRR is a great return metric, especially for housing, as IRR assumes that you take any proceeds from investment and reinvest them in similar returning investments. with real estate, this is impossible as whatever cashflow you get from your rental properties is not going to be enough to purchase another house.

In my opinion, ROI or ROE is the best metric to use, but why show average? just show what it looks like annually using a line graph. Then it shows that your ROI gets better and better as you hold onto investment longer. You can even compare your ROI vs S&P returns or something to show that your returns are (hopefully) better than the stock market.

Another thing you can do is come up with what's called PME (Public Market Equivalent). You take the cashflow from your investment, and assume that you invest/distribute same amount from a public market index. For instance, if you invest $20K in your new home, you create a hypothetical track record that "purchases" a share of whatever index you want to use (probably S&P or a REIT index). then, every time you have cashflow from your property, its treated as selling the index. At the end of the day, you are basically calculating an IRR on your property vs this hypothetical investment in the index to show that your investment would have generated a better IRR than if you've invested in an index (Yes it's a function of IRR sorry!).

Hope this helps!

I agree with @Michinori Kaneko    You are not looking for an equity partner, you are looking for a debt investment.   Those investors want steady returns with the securitized asset.  

That said I am with you.   Like Warren Buffet said  "If you are giving me 10% on my money I don't ever want it back".    But in my very limited experience in the private equity world, everyone has an exit date.