Valuation Methods in Commercial Real Estate, Part 2
Written by Darren McCorkle
Last month we talked a bit about capitalization rates (aka cap rates), a valuation method commonly used in commercial real estate. It is certainly a valuable tool, but it is far from perfect. Luckily we are not completely out of options. Internal Rate of Return (IRR) is another valuation method frequently used in commercial real estate.
To quickly recap (no pun intended), to calculate a cap rate you simply divide the Net Operating Income (“NOI”) for the first year by the purchase price. This indicator can then be used to market to investors, who will typically have a preference as to the type of cap rates they are comfortable with. Conversely the investor could go into a property search with a cap rate in mind, and use it to calculate how much they would be willing to pay for a given property with a known NOI. There are several shortcomings, however. Because you are basing your calculations off of NOI, you do not take taxes or financing into account. Additionally, because it is based off of only the first year’s NOI, it does not address the investment’s ongoing performance. Luckily IRR addresses both of these problems.
Internal Rate of Return is defined as the annualized discount rate at which a stream of future income is equal to the initial investment. Or to put it another way it is the annualized yield generated by each dollar of an investment over the duration the investment is held. This makes it an excellent tool for dealing with income property. It is a flexible methodology, but not without some limitations as we will see below. As with other types of investments a property’s rate of return is tied to its risk; if there are two properties with the same income, the market will dictate that the one with the higher risk is more likely to have a higher IRR, (as it would have a lower sale price) and vice versa. It is up to investors to determine the levels of risk and reward they are comfortable with. As with any methodology it has pros and cons, which we will discuss below. But first, here are some examples:
Example 1
In this very simple example the cash flows are regular. An investor who is interested in the property might be curious to know with a $10,000 initial cost, $11,000 sale price, and a projected yearly income of $1,000, what kind of yield they could expect. Using the information given, solving for IRR can be simply achieved using any financial calculator.
Example 2
This example is identical to Example 1, except for a very different cash flow. As you can see, this has a large effect on the yield.
Example 3
In this case, because there have been negative cash flows, IRR is not a feasible solution; negative cash flows can result in multiple results when solving for IRR. This won’t stop a calculator from giving you an answer though, so be cautious!
Example 4
If an investor has a specific target yield in mind, the IRR process can also be used to determine what they should pay for a property with a given projected cash flow and disposition price. This is achieved with a simple Net Present Value calculation. In this case to achieve a 10% yield on the example property, the investor should buy it for about $18,000.
Internal Rate of Return has several significant advantages compared to cap rate. For one, it provides a valuation method that takes into account the expected performance of the property over a period of time. This is of lesser importance if the property in question is extremely stable (such as a single tenant investment or land lease). However, this is all too rarely the case. In instances where the property might have uncertain times ahead – or conversely on a future development with an assumed lease-up – IRR is much more relevant.
IRR is a very flexible methodology. Four pieces of information are involved with the IRR process: initial investment, cash flow over a known number of years, projected sale price at end of holding period, and the IRR itself. The beauty is that if you know or project any three of these, you can calculate the fourth. This means that if you have a projection for your eventual disposition price and know how much the property will cost to acquire, you can determine the cash flow you will need to achieve a certain yield. Or if you know the expected cash flow and disposition price, you can determine the price you will be able to purchase the property for in order to hit a desired yield.
IRR can also be used to evaluate an investment with regards to any combination of income, tax, and debt. Is your goal is to simply evaluate the property based off of income before taxes and debt service? Then use the total price of the property and the NOI (with disposition price). Want to see what the return on your equity will be at the very end of the line? Then plug in your initial equity investment and projected cash flow after taxes. Et cetera.
Despite these benefits, Internal Rate of Return does have some limitations. Perhaps the most basic is that it is simply not easy to calculate; cap rate is simply the division of two numbers, while IRR requires a more complex mathematical solution that only gets more complicated as the number of years increases. A calculator or computer can of course calculate it with no problem, but it still cannot be done “on the fly”. IRR also requires a specific situation – an initial cash outlay followed by at least one year of cash flow (including proceeds from disposition). As such it cannot give any insight as to how the property is performing year to year, for example. And of course it suffers the same problem that any investment analysis based off of future performance faces – the underlying assumptions about the future cash flow could be wrong. Or in other words, no one can predict the future.
IRR is also a poor method of comparing two mutually exclusive properties. This is for several reasons, the first being the most obvious. In the absence of information about the amounts being discussed, the comparison between two rates becomes meaningless; a $20 investment with a $40 return has a higher IRR than a $1 million investment with a $100,000 return. Negative cash flows can also be problematic; because of the way the mathematical equation for IRR is solved they can lead to multiple solutions, which makes the result somewhat meaningless. Differences in initial investment and holding period also cause difficulty. IRR fails to take into account that, given two properties with a price difference, the yield you will be able to make on the savings by purchasing the cheaper property may not equal the projected IRR. Likewise, if you have two properties with different holding periods you would have the opportunity to continue investing the money you get out at the end of the shorter investment for the . IRR makes no assumption about this reinvestment opportunity.
And finally, one of the most major drawbacks is that it does not take the reinvestment of operational cash flows into account during the length of the investment. Or in other words the cash flows you have coming out of the property (from rent) come out of the investment and just sit there! As a result it is not an all-inclusive model. This is not a problem if the investor’s goal is to take those operational cash flows as income. However, they very well may wish to reinvest it, in which case IRR is not relevant.
This all may seem to paint IRR in a negative light. The thing to keep in mind is that despite these limitations, it is still a very powerful valuation methodology that can give a lot of insight. While it may not be good for comparing investments, it does act as an excellent metric for judging an investment on its own terms and seeing if it meets the investor’s unique investment criteria. Next month we’ll discuss some additional evaluation tools.
| Dougall McCorkle, MBA Sales Associate and Commercial Specialist Premier Commercial, Inc., Licensed Real Estate Brokers Direct: 239.213.7234 Cell: 239.860.3368 dougall@premiermail.net | Darren McCorkle Sales Associate and Commercial Specialist Premier Commercial, Inc., Licensed Real Estate Brokers Direct: 239.213.7223 Cell: 239.207.8668 darren@premiermail.net |