Real Insight. Real Estate.

Posts Tagged ‘IRR’

Editor’s Note: Several of us at Llenrock Group have been teaching a course on the capital markets for commercial real estate broker’s continuing education requirements for the states of Pennsylvania and Delaware. As part of a three week blog series, Questionable Brokers will  posit questions we have received in such classes from various brokers from the Tri-State area regarding the capital markets. We felt it would be useful for other brokers to see the kinds of questions their peers are asking, and a useful tool to our other readers who may have some of the same basic questions on the capital markets. We will divulge names and companies for a fee. Just Kidding. On second thought…it depends on how much you offer. The first part of the series will examine questions regarding Real Estate Metrics.  Next week, we will feature questions regarding Types of Capital, and the following week, we will examine questions regarding Deal Structure. Enjoy!

Q: Does the IRR metric still carry the same weight as a measurement for property valuation given the state the market today?

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The typical approach to analyze potential real estate investment and development opportunities is the discounted cash flow model. In the most basic sense, the user makes input assumptions such as purchase price, LTV, NOI growth, terminal cap rate, and expense growth to get the outputs: Internal Rate of Return and Net Present Value. The standard decision rule is that if IRR is higher than the investors required rate of return and the NPV is positive, then the investment should proceed. To supplement this decisions making process, a sensitivity analysis is often conducted. To create a sensitivity analysis the user changes various inputs and records their effect on the output Ceteris paribus. There are several limitations with the DCF model, including that the value of the property is needed to compute the discount rate, the discount rate is assumed to be constant during the entire holding period, and uncertainty is not explicitly taken into account.

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Real Questions…

…. and Unintended Consequences

Question 1:

If you are a buyer of real estate (and actually have capital), what sort of IRR are you looking for? 20%? 30%?

Question 2:

If you are an owner of real estate, why on earth would you sell into this market unless you absolutely had to?

These questions succinctly sum up the entire commercial real estate market. Other statements examine facets of the problem, but they all revolve around this problem we’ll call, “The Bid/Offer Spread”.

Every day, the fund managers who still have jobs wake up, read the Wall Street Journal and say to themselves, “If I’m going to buy a property, I deserve a discount.” Any possible ‘green shoots’ notwithstanding, unemployment is high, the economy is in recession, global icons are getting destroyed (or taken over by the government), and the banking system as a whole is only viable because the Feds have stepped in with HUGE assistance programs. You can also throw in the fact that recent liquid market action (rally in gold, commodities and TIPS while the 10yr notes sells off ) is telling us we might even have an inflation problem in the not-so-distant future. Read the rest of this entry »

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