What’s a Good Return? The Importance of Chasing the Right Returns

At the end of last year, we wrote about why we intend to be net buyers in 2019 and why we trust our value-add business plan. Well guess what? It’s Q2 and we’ve seen that lots of other groups feel the same way–every potential deal we’ve looked at has either been way overpriced, super competitive, and usually both. Also, every one of those deals has sold. The market remains hot and multifamily assets continue to see an influx of institutional and international capital.

In underwriting those 35+ deals over the last couple months and submitting 8 offers, we’ve had an interesting dialogue internally about what this means, how it impacts our underwriting and what we can and should pay for some of these deals. At the end of the day, conversations about purchase prices always tie directly back to investor returns and investor expectations. The more we pay for a deal, the less return we can offer investors. But does a lower return mean the investment is a bad one? Do higher (marketed) returns always mean the investment is better? Just what is a good return?

As we’ve gone down this rabbit hole, it’s led to many discussions with current & potential investors, with brokers, and with other operators. How do investors think about risk, and evaluate potential returns–whether the investment is in real estate investment, stocks or something else entirely? How are those thoughts evolving and changing as we continue in a hot market for investments of all types, but also prepare for a possible slow down in the next year or two?
There is a lot to discuss and digest on this topic, and we think it’s a critical conversation to have–so we’ve dedicated our next three articles to cover this. Over these 6 weeks, we hope to start a dialog with you related to the following topics:

• What goes into defining a “Good Return”
• Compare Disparate Asset Classes Apples to Apples
• How we Evaluate Opportunities

Here’s part 1…

Part 1: Defining a Good Return.

As an investor, we are all looking for good returns. But “Good” is such a relative term. Good compared to what? Cash sitting at the bank? An angel investment in the tech startup that’ll disrupt Facebook?

When we say good returns, what we believe we mean to really say is good “risk-adjusted” returns. Everyone is looking for the best possible return with the least possible risk. In an efficient market you have to accept higher risk in order to chase a higher return. That’s Investing 101. Obviously for us, we feel that Real Estate, and Multifamily specifically, provides that best combination of risk & reward. But if we’re going to try and define a good return in this article, first we need to dimensionalize the term “return”. In most investment opportunities that we look at, there are four primary metrics we’re underwriting to:

1. Cash on Cash Return
2. IRR
3. Equity Multiple
4. Preferred Return

Every investor we know has their own formula for evaluating which of these is most important to them. Are you cashflow driven? Or are you looking at your annualized returns via IRR? Perhaps you want a bit more certainty delivered via a preferred return and give up some potential upside? Typically, we’ve seen investors lean towards one metric more heavily than the others–based on the type of investor you are and your goals. Within each vector though, there are a myriad of decision points, all of which can help define what a good investment is (or isn’t). As you prioritize one over the others, naturally you’ll see the numbers in the other categories go down.

As an example, take “Jim”. Jim is investing for cashflow. He values getting quarterly checks to provide mailbox money, so Cash on Cash Return is most important to him. He’s going to be more attracted to an investment opportunity that provides a 10% Cash on Cash Return with regular dividends, even if the IRR is “relatively low” at 12%. Over a 5 year hold he may see lower overall returns but he’s happy because the investment is meeting his needs. On the other hand, “Susan” is focused on growing her wealth. She’s most attracted to investments with IRR’s of 25%+ and Equity Multiples of 2.5x. She understands these are inherently more risky, but figures if she can hit on a few of them, she’s closer to her goals. As a result, she’s not focused on investments with any real cash distributions. Both people are approaching investing with wildly different risk tolerance, and definitions of what a good investment is.

That seems pretty simple, but here’s where we think more consideration is needed. What about someone who is focused on a single metric, say IRR, as the most important factor. Is a higher IRR always better? Is a deal that markets a 17% IRR deal better than another deal showing a 12%? Do you instantly jump at the 17% return? Going back to the theory of efficient markets, all measured returns also incorporate a measure of risk. As you start your due diligence, you may learn that the 17% opportunity is in a crime-riddled neighborhood that would optimistically qualify the asset as a Class C property; meanwhile the 12% opportunity is in an established neighborhood located in a strong growth corridor with strong amounts of jobs nearby. Which opportunity are you more attracted to now?

Similarly, the markets matter. There is currently a rush to tertiary markets as operators and investors chase seemingly higher returns. But again, with higher returns comes higher risk. As an investor you have to decide if you believe in the growth prospects and underwriting of every investment opportunity you see. Is said tertiary market slated for continued job and population growth? Will it support rent growth while maintaining occupancy? On the flip side, will opportunities in primary markets face too much new supply coming online? Are you paying too much going in?

At Wildhorn Capital, we’re in the camp that larger markets and nicer properties provide the best overall mix of risk and reward. That’s why we focus our acquisitions on true Class B properties in infill locations of major Texas cities. We believe that a 12% IRR and 6% Cash on Cash Return in a market like our hometown of Austin is an unbelievable investment with little risk. And while those returns are lower than what you would have seen 2 or 3 years ago, they still stack up nicely to other investment opportunities out there.

Talking with our peers and investors, they have tended to agree with us. We’d love to hear from anyone else out there as well, what is a good return? And as we continue this conversation over the next couple of articles, look forward to diving in even further.