When looking at the returns for a particular investment it’s important to understand that the there are several different factors to consider and not just the overall return of an investment. The ratio between Cash on Cash return and IRR is something you will want to pay attention to that can easily be manipulated. A 50% ratio is a good rule of thumb between these two factors, meaning you will receive half of your return during the life of the hold (Cash on Cash) and the other half upon sale (IRR). Seeking only an overall investment return could be a mistake as it could blind you to digging in and asking the right questions. In a situation where you are investing in an opportunity that is heavily weighted towards IRR over Cash on Cash, much of the returns are based off of the speculation of how the market will be performing in the planned sale year. Therefore, you could be waiting several years to make your return with none of it ever coming to you if that assumption was incorrect. You could say the same of Cash on Cash returns but those are more projections based off of current NOI, market, neighborhood and property factors; and not an assumption of where the market will be in the future.
Much like you would question any sponsor on their underwriting assumptions, one key area that can change the returns of any deal is the exit cap rate, which can drastically change the IRR. Because of this, it is easy for a sponsor to have an opportunity that is heavily weighted on IRR to make an investment look appealing. This is why you should always pay attention to the exit cap rate of any investment. Now, how do you determine what exit cap rate is considered ok? This is where the market cap rate comes in and each market will have a different cap rate based on many economic factors which we will not get into here. You can find out the market cap rate of most major markets by simply calling local brokers and asking them or finding market specific market reports which are available online and also provided by most large brokerages.
The market cap rate is more important than the purchase cap rate in my opinion when it comes to evaluating the exit cap rate of a value add investment. The purchase cap rate certainly has its place but is more tied to how much value there is to be added to a given investment and can be strategically maneuvered. Here are a couple of examples why you should focus on the market cap rate vs purchase cap rate when evaluating exit cap rate of a value add investment.
Market CAP rate – 5%
Purchase CAP rate – 6%
Exit CAP rate – 6%
In this example, if you are evaluating based off of the purchase cap rate you are discounting the fact that this was purchased below market value and therefore discounting or limiting it’s potential upside. This to me is a safe exit cap for a 5 year hold, as it is 100 basis points higher than the market cap in this location. This means that the sponsor is assuming that the market conditions are going to be worse over time which is a conservative and prudent assumption. That being said, there is always a story behind every property and you should ask about the story and fully understand it. In this example, we are assuming the 5% market cap rate is 5% in the neighborhood that it was purchased as well.
Market CAP rate – 5%
Purchase CAP rate – 4%
Exit CAP rate 5%
In this example, you may be looking at the purchase cap and say to yourself that the exit cap is 100 basis points higher than the purchase so this is safe. The problem is this property was overpaid for, as the market cap is 5%, so the exit cap projection is 0 basis points higher than the current market cap. At this point, my advice would be to dig in a little deeper and understand why. Estimating the exit cap to be the same as the market cap at purchase is an aggressive assumption. What this situation is stating is that the market will be just as strong in the future as it is today.
Here is an example on how much an exit cap rate can change the IRR of an investment.
Projected returns of an investment are 8% Cash on Cash and 15.24% IRR (this is a good ratio, a 52% ratio of Cash on Cash to IRR). Here you are not over leveraged on the IRR. To show the affect an exit cap rate can have on a project, below is an example in this situation to show how easy it is for a sponsor to get the IRR up.
Let’s say the exit cap rate in the above example for a 15.24% IRR is 5.7%. If changed just 50 basis points to 5.2% the IRR goes up to 18.27% and changes the ratio of Cash on Cash to IRR to 44%. On the flip side, if the exit cap is changed from 5.7% to 6.2% the IRR is now 12.46% and the ratio changes to 64%.
This is not to say that an investment that has a Cash on Cash to IRR ratio of lower than 50% is not a good investment. There are several that could be. However, if this ratio is below 50% (especially the further it is from 50%) you should be asking questions to better understand why and what the story behind it is. From there, it is up to you to make the decision on moving forward.
The ironic thing about this example is that if these two scenarios were the same property but just presented differently from the sponsor; and they hit their 8% cash on cash return, in the end you will get the same exact overall return. Because no one can predict the exit cap rate (sales price), therefore the back half of any investment is speculation. For this reason, the Cash on Cash return is just as important (if not more important) as your overall return and you should be considering both sides of this equation and not just the overall return.