We made a promise to you earlier this year to provide updates and regular content from other members of our Executive Team. We have sent you several reports from Valentina Pedrotti, our Biologist and Value Chain Analyst, and you recently heard from Armando Choco, our Executive Chocolate Maker.
Now we are proud to share with you the first in a series of articles from our Financial Analyst, Jake Smith. Take it away Jake!
Many investments in private equity, whether they be in agriculture or commercial real estate, advertise a hold period of 3-10 years and a sale at the end of the period. In many of these offerings the bulk of their projected returns are derived from the disposition of the asset rather than the cash flows the asset actually produces.
Sort of like flipping a house. There is nothing inherently wrong with this model, and with a good sponsor it can result in excellent returns. However, when forecasting an asset’s disposition, small changes in the exit capitalization rate at which you sell it (AKA, cap rate, is the Net Operating Income divided by the price, x 100 to get a whole number), and the year in which it is sold can have a dramatic effect on the returns. It is here that some overzealous syndicators can get into trouble.
Because the returns are so heavily dependent on the sale of the asset rather than the cash flows themselves, if for any reason that sale doesn’t happen as anticipated, the negative impact on investor returns can be massive.
Let’s return to the concept of house flipping for a second. Imagine that you buy a house and, because you intend to flip it rather than hold it as a rental, you don’t consider whether the rent is high enough to cover the mortgage and operating costs. And who cares? Property values have been going up for years without a hiccup.
You’re sure you’ll be able to sell it for a profit. So you invest thousands of dollars rehabbing the house and now it obtains higher rents, but still not enough to justify the investment you’ve made in it. Now, due to coronavirus, or a new housing development right up the street, or because it’s 2008 and the real estate market is imploding, you can no longer sell the house at the price you need to earn a good return.
Your plan to sell the house for a profit goes out the window and you’re stuck paying the difference between the rent and the mortgage. This is similar to what can happen to the overzealous syndicator mentioned above who’s paid top dollar for an apartment complex using several tranches of debt, one of which may even have a 5 year balloon payment, is priced to perfection with 40% lower operating costs than the previous owner, rent increases of 5% a year, 98% occupancy and a capitalization rate at disposition of 3%. The syndicator and you the investor, although in a great asset class like apartments, are now in a very precarious place dependent on everything going right to hit your returns.
To put some numbers behind this, below is a simplified apartment complex deal with two scenarios:
Here in scenario 1 everything goes according to plan. Cash flows are thin, but it’s all good because we got the sale price we wanted in the time frame that we needed to hit our returns and our investors are happy.
But here in scenario 2 you really get a sense for just how sensitive the projected returns are to the exit cap rate we use. At just 60 basis points higher my expected IRR drops by over 50%, and the ROI by 2/3.
It is important to note that the longer the time frame used in the IRR calculation the less sensitive the returns will be to changes in the exit cap. This is because the IRR formula takes into account when cash flows are received.
So at a 20 year time horizon a sale will have a smaller effect on the returns shown by the IRR. In contrast, the ROI will only show the actual dollar returns vs dollars invested without regard for the timing of payments or inflation. Again, the use of an exit cap rate, and/or, a short hold period is not an inherently deceitful or uncommon practice, especially in commercial real estate; it’s just important as an investor to be wary of how these can potentially get you into hot water.
For these reasons the majority of our offering returns are based off of cash flows alone with no disposition forecasted. We do use a 20 year forecast period (without a sale) to be able to calculate an ROI and IRR, but we like to think that most of our investments should be held indefinitely as a legacy asset. It is our opinion that this is a generally more conservative way to run the numbers, and we also like to think that if you have confidence in a business model and team you should want to hold on to your investment over the long term.
The bottom line is that if you’re going to invest in private equity you need to understand how your returns are being forecasted and be extremely confident in the team you’re investing with. So on that note, I hope this letter and future ones will add to your toolbelt as an investor and better arm you to ask insightful questions to your deal sponsors.
To Your Health and Wealth,