Planning for the End
All new relationships start with a bit of nerves, a lot of excitement and typically, big hopes for the future. Whether it is a new marriage, a new friendship or a new business partner.
For the Passive Investor, we are focusing on the business partner. As you are interviewing sponsors, often times the focus is on their business plan, track record and overall experience. But, how much time are you focused on the end, the exit, the divorce? Particularly in real estate investments, the exit is a primary driver of overall returns, whether it be core, value-add or a development deal.
Let’s take a look at an example:
A core asset is purchased for $160,000,000. This is a luxury asset in a very good, high income area with strong population growth. The purchase price is about $400,000/door. The sponsor is projecting a 6% average annualized cash on cash return, 15% IRR and 2.5-3x equity multiple over a 10 year hold. This sponsor offers a straight 80/20 profit split from day 1 with no preferred return.
These numbers allow us to get a rough estimate of what the terminal sale value must be to achieve these numbers. Saving you the boredom of my simple excel model, the sales price in year 10 would have to be $261 million dollars, or 61% more than the purchase price, accounting for a year 2 refinance. This equates to $652,000/door.
Is this sale price achievable?
As investors, we are all speculating as to where values are going. Whether the hold is 1 year or 10 years, if I invest today it is because I believe values are going to rise over that period. The point is to ask the question and confirm the sponsor has thought this through.
Of course, there are a multitude of factors that can affect the terminal value of the asset. Some simple questions that I ask sponsors when assessing the projected sales price:
- Are there comps today that support that price in total dollars?
- Are there comps today that support your terminal cap rate?
- Are there comps today that support that price per door?
- Who is the likely buyer?
Notice I focus on CURRENT comparable properties, as my crystal ball is realistically no better or worse than anyone else’s. If a sponsor is projecting to sell a deal for $100,000,000 at a 5.0% cap rate and $250,000 per door, I will want to see comps showing that the sale of the asset I am invested in is not going to be a record breaker in two out of three of those areas, and ideally all three. As for the last question, while no sponsor can speak to who the specific buyer of an asset will be in 5-10 years, the purpose is to better understand that a) the sponsor has thought about the reality of an exit, and b) better understand if buyers exist in the market at that price.
At the end of the day, each investment is a balancing act of risk. Asset classes, property types, business plans, sponsors, leverage, time horizon are all pieces of the equation that need to be addressed, and many of these are commonly asked in my dealings with investors. But at the end of the day, the only thing that matters to most people is WILL I MAKE MONEY? Understanding where that money is coming from and assessing the feasibility of those results is imperative to answering that question.
Check out other red flags to look for when vetting sponsors here.
About the author:
Evan is the Investor Relations Consultant for Ashcroft Capital and Active and Passive Real Estate Investor. As such, he spends his days working with investors to better understand their investment goals and background. With over 13 years in real estate, he has seen all sides of real estate from acquisitions, to capital raising on the equity and debt side, to operations, and actively invests himself. Please feel free to connect with Evan here.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.