The Truth About IRR, Leverage, & More

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Welcome to The Multifamily Download, a weekly newsletter where I provide institutional insights to help you build an exceptional Multifamily career.

Today at a Glance:

IRR: The Good & Bad
Leverage: Positive vs Negative
Sentiment: Berkadia Survey
Weekly Listen: Michelle Herrick, JPMorgan

IRR

For those of us in the Multifamily investment space, IRR is one of the most highly scrutinized components of any potential investment.

Some will tell you that a higher projected IRR is better, because it indicates a higher potential return.

Others will tell you that the same high IRR indicates higher risk.

Still others will tell you that a lower IRR is better because it's less risky.

So what's the real story?

This section will attempt to share helpful context, pitfalls, highlights, and alternatives to the infamous IRR metric.

Context

Investors generally agree that it's important to include time as a determinant of the performance of an investment.

Enter: IRR (or if you're fancy, XIRR), which is an equation for calculating the compounding annual return that an investment much achieve to get from the starting amount to the ending amount.

Essentially, the IRR is a time-bound metric that allows for relative comparison across investment opportunities, asset classes, and even industry sectors.

The IRR tells an investor how much they'll earn per year on a compounded basis.

The question that most investors consider:

Should I be attracted or deterred by lower or higher projected IRRs, and why?

This is the wrong question to ask, because it's inherently outcome focused.

Ask this question instead:

How will this projected IRR be achieved, and do I agree that the embedded assumptions are rationale?

Think critically about the assumptions, and the outcomes will become obvious.

Pitfalls

To some, IRR is controversial because of the time component.

It's important that investors match their dollars with investments that align with their goals.

Some investors want a higher velocity of capital, and they're okay with their capital being returned in 12 to 18 months if the returns exceed the original projections ("Proforma").

Other investors want a steady or lower velocity of capital, where time becomes their ally as inflation erodes the dollar and their asset continues to rise in value over a mid- or long-term time horizon.

Regardless of the approach, and as I've written about previously in TMD 009, incentives drive behavior, and IRR is no different.

Typically, distributions between the General Partners ("GP", "Sponsor") and the Limited Partners ("LP", "Equity Investor") are predetermined according to a waterfall structure with varying hurdles based on specific IRR outcomes.

In simple terms, the better the investment performs, the larger the portion of overall profit that gets funneled to the GP. At face value, this is a productive incentive, as it motivates the GP to continually strive for evermore outperformance.

But what about times when the market delivers the outperformance?

Let's time travel back to Phoenix in 2021. Rent growth was in the double-digits, cap rates were sub-4%, and capital was flowing into Multifamily value-add assets at a voracious pace.

Let's say that a GP projected a 15% gross IRR on a 3 to 5 year hold period. But, with the perfect storm outlined above, the GP realizes they could sell the asset after just 15 months and return the capital that was promised to investors on the original 3 to 5 year hold period, AND the GP could earn an extremely healthy portion of the profits ("promote") along the way.

Let's say, for example, that if the 15% gross IRR had been achieved on a 5 year time horizon then the GP promote would have been 20% of the profits.

However, because of the rapid NOI growth and feverishly aggressive market, the 15 month hold period generates a 100% IRR and the GP promote becomes 50% of the profits.

So, not only were future profits shifted from the LP to the GP due to the condensed time horizon, but the LP investor is now back on the market looking for a new investment in a red hot market.

The natural inclination? 1031 exchange with the GP into the next deal.

The caveat: The LP may have 1031 exchanged all of their proceeds, but the GP gets to ring the fee register again, and pocket those fees.

Now, let's consider the market went the other direction, and that any hope of the GP earning a promote seems to be evaporating. Would you, as the LP investor, be excited about a disincentivized GP in charge that is unlikely to earn meaningful dollars from their oversight of your investment?

Because of IRR's time component, the more time that passes, the better the asset must perform just to maintain an equal promote for the GP. As time passes and the exit looks less impressive (think: trying to sell in 2023-2024), the promote erodes away. Lose-lose for both GP and LP.

The scenarios described above between GP and LP including the investment hold period mismatch, shifting profits from LP to GP, and over-collection of fee income can create a disastrous misalignment between the Sponsor and the Equity Investor.

Highlights

Despite the scenario outlined above, IRR is a beautiful metric in many regards, particularly because it incentivizes performance within a time bound environment.

As an LP, it's not inherently a bad thing for 3 to 5 years of projected returns to be realized and returned after just 15 months, so long as that potentiality was disclosed and carefully considered prior to the investment being made.

IRR keeps the GP focused on executing the business plan and constantly looking for opportunities to add value, grow NOI, and maximize the equity capital invested.

Alternatives

What if IRR isn't the only way?

Imagine if the profit sharing was determined whereby the return hurdles and participation percentages shifted depending upon the hold period of the investment.

For example, what if the LP / GP split was 80 / 20 after the return of capital plus a preferred return until the LP achieved a specific MOIC (Multiple on Invested Capital), and then the split adjusts to 70 / 30 to the next MOIC, and then 60 / 40?

Now, add a variable in which the MOIC split at each hurdle adjusts based on the time component, to ensure that the LP is being rewarded for holding the asset longer.

As such, it would make sense to raise the MOIC targets as time goes on, because assets typically go up on a longer time horizon, and it wouldn't necessarily be commensurate with the equity risk if the GP earns a larger portion of the profits simply because the property was held longer.

I'm a proponent of both IRR and straight splits, but my preference often depends upon the investment strategy.

For example, a coastal legacy asset should not be time bound, as the downside risk is relatively low and the upside is likely tied to longer term appreciation, as compared to a development project where time should definitely be measured (and rewarded) using IRR since developing is a shorter term investment with more inherent risk.

This section doesn't cover every nuance of IRR, but my hope is that it gets you thinking about incentives, alignment, and trying to mentally sit on both sides of the table (GP vs LP) before you make your next investment.

What do you think? Hit reply and let me know.

P.S. Today is my half birthday. Can you share this link with anyone that may enjoy The Multifamily Download? Thank you!

Leverage

Positive leverage in Real Estate is when the cap rate is higher than the loan constant. (Most simplify this by saying that positive leverage is when cap rate is higher than the interest rate, and that's okay). More debt = better returns.

Negative leverage is when the cap rate is lower than the loan constant. More debt = worse returns.

Generally, Real Estate investors prefer to buy positive leverage assets so that they can earn money on the bank's money.

However, there are a few situations in which investors will buy negative leverage assets.

1. Projected NOI Growth

If there's a clear path to rent growth, expense reduction, and ultimately NOI growth then investors may be willing to acquire assets at negative leverage.

2. Falling Interest Rates

If an investor believes that rates will be lower in the future, then perhaps they'd be willing to take on negative leverage today with they can execute a cash-neutral or cash-out refinance in the future when rates drop, thereby engineering positive leverage at that point in time.

3. Unlevered Acquistion

Wealthy or institutional investors may elect to buy trophy assets without any debt at prices that would equate to negative leverage if they had taken on debt. This is generally because they believe in one or both of the scenarios above.

Acquiring Real Estate in a negative leverage position is not for the faint of heart. Doing so takes tremendous courage, conviction, and execution.

Berkadia

Earlier this week, Berkadia released their inaugural Multifamily Investor Sentiment Survey.

I covered this briefly on my recent LinkedIn post, but I thought it was worth unpacking further here.

Below are several highlights that I thought to be noteworthy.

Performance: Outlook on Class A performance relative to Class B or C was split, with 46% believing it will outperform and 32% believing it will under-perform. My take: Class A will outperform in 2025.

Investment Profiles: 43% of respondents think Core-Plus will generate the best risk-adjusted returns, with 30% choosing value-add. My take: Core-Plus will generate best risk-adjusted returns.

Underwriting: 93% of respondents believe it is either very difficult (48%) or somewhat difficult (45%) to make the numbers work when underwriting multifamily today. My take: It is very difficult. Seller expectations are not aligned with the risk that Buyers are taking for transacting today.

Strategy: 83% of respondents expect to moderately (65%) or aggressively (18%) expand their portfolios in 2025. My take: Moderate expansion is most likely for many.

Exit Cap Rates: 40% of respondents are underwriting exit cap rates equal to their going-in cap rates, while another 38% are underwriting 50bps or less of cap rate expansion on exit.

Operational: Challenges include insurance costs, labor costs, maintenance and repairs, regulation, and utility expenses. My take: Insurance will be tough. Labor will be location-specific. Utilities will trend downward (positively).

Regions: Respondents believe the Southeast, Midwest, and Texas will be best for Multifamily investments in 2025.

The survey includes graphics to accompany the above information along with additional commentary.

You can get access to the survey here.

Weekly Listen

This week's listen is a recent episode of the Walker Webcast hosted by Willy Walker with guest Michelle Herrick, the Head of Commercial Real Estate at JPMorgan Chase Commercial Banking.

Featuring a live conversation in Florida, Willy and Michelle discussed numerous topics including: Michelle’s education and leadership journey; Working with Jamie Dimon; Overall view on Office as an asset; The best and worst part of portfolio management; How to lead tough conversations with borrowers; Returning and extending loans; Advice on asset financing; Buying First Republic and acquiring loans; Thoughts on financing data centers; The largest request for a single loan; Is JPMorgan pulling back on hospitality?; How Fannie and Freddie’s privatization will impact JPMorgan; Providing excellent service in difficult times; Development in major cities; and, Balancing motherhood and career.

You can listen to the full episode here.