First, we will go over the fundamentals. How portfolios are benefited by real estate, common strategies, and portfolio allocation guidelines for private real estate. From there, we will help you get past glossy property brochures so you can make sure a potential investment corresponds with your own risk tolerance and investment goals.
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Many investors mistakenly compare IRR to annualized returns to make investment decisions, which can be a costly mistake. IRR, on the other hand, attempts to give investors the equivalent annualized rate of return but takes into account the timing of cash flows, even if money is invested for short periods of time such as days or weeks. IRR also assumes all distributions will be reinvested immediately, which means there is a built-in compounding assumption that actually doesn’t happen. Real wealth is created through the compounding of money over time, which is captured in the annualized return metric, but not IRR.
One key metric that investors need to pay close attention to when comparing real estate deals is the amount of leverage used in the capital structure. In other words, how much debt is being used to finance the property and generate the returns? Simply put: more leverage means more risk. Debt can enhance returns when projects go according to plan, but it also works in reverse.
The value of private real estate is based on the actual value of property. Conversely, in a public REIT, the share price value is determined by daily market forces, which means the share price of a public REIT may not reflect the actual value of the underlying real estate. In some cases, the share price can value the REIT 30% higher or lower than the actual value of the underlying real estate. Private real estate values don’t move much on a daily basis but rather appreciate slowly over time, which is why private investments are less volatile than their public counterparts. Both vehicles have pros and cons and the optimal portfolio has a combination of both. Public markets offer liquidity, but that comes at the expense of volatility and private investments offer investors low volatility, but with that comes illiquidity.
A cap rate is the rate of return you’d expect to receive from a property during the first year of ownership, excluding the cost to improve the property and financing costs. Think of a cap rate as the dividend one would receive in the first year if the property were acquired with all cash. The cap rate is calculated by taking the Net Operating Income (NOI), which is the property revenue, minus the necessary operating expenses, and dividing it by the purchase price.
Return on Cost is a forward-looking cap rate; it takes into consideration both the costs needed to stabilize the property and the future NOI once the property has been stabilized. It’s calculated by dividing the total project cost by the potential NOI. We use return on cost to determine if we’ll potentially generate an income stream greater than what we could achieve if we purchased a stabilized asset today.
The waterfall defines the way in which cash distributions will be allocated between the sponsor and the investor. Waterfalls, clawbacks and catch-ups are terms used in private investing that define how distributions flow from the investment to the partners, what happens when things don’t go as planned and dictate the terms of the manager’s performance fee. Every investment has a defined waterfall and it’s important to understand how it works because an unfavorable waterfall can tilt risk towards an investor.