In this episode, Travis shares his thoughts on two very different value-add multifamily deals he was a part of as an LP in the past. He uses these examples to explain why focusing on net operating income (NOI) versus simply evaluating an operator by previous IRRs can make a huge difference.
This deal had a high IRR, but Travis wonders how that return was actually achieved. Did the operator deserve all the credit, or should he be thanking the market instead? An operator can deliver high returns if they operationally improve a property by increasing the net operating income and the fair market valuation increases substantially. However, they also could simply find a good deal at a good price, then happen to receive an above-market offer.
In another deal, the operator projected a 20% IRR, but the investors only received 10% in the long run. Travis believes the operator bought a good property at a good price in a good market at a good time, but they did not execute the business plan the way they intended to. They exited out of the deal early without having done much. “Interest rates were coming down, cap rates were compressing, it was a growing market, so we ended up making, in my opinion, a 10% return just simply because the market increased,” Travis says. The market essentially bailed them out.
NOI vs. IRR
After considering these deals, Travis says net operating income is the most important value-add metric that nobody talks about. If an operator has historically effectively increased their properties’ net operating income by 30%, that means they went into the property and cut expenses, increased rents, or did both.
“If you had bought a single-family home … in 2018, and you were selling it today, you probably made money,” Travis explains. “But that doesn’t mean that you’re a smart investor. That doesn’t mean that you did anything to the property — that means that the market went up.” Focusing on NOI rather than IRR can help you weed out those operators that have relied on the market to bail them out in the past.
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Travis Watts: Hey Best Ever listeners, welcome back to another episode of The Actively Passive Investing Show. If you're tuning in on audio, I apologize, I'm shooting this on my phone, because I'm on a walk. I haven't done one of these episodes in a while like this, but sometimes I get these little epiphanies or ideas that I want to share with you guys. Sometimes by the time I get back home, I've forgotten half of what I wanted to say, so I go ahead and I record them out here.
With that said, there was something on my mind... I was in a recent deal as a limited partner. That deal just sold, and the IRR return, the internal rate of return was quite high. It was high to the point where you might say that's a fantastic return, that was an awesome syndicator blah, blah, blah. But I got to thinking, how was that -- sorry, there's a little moped in the background. I got to thinking, how was that return actually achieved? So how much credit should I give to the operator, versus just what happened in the market?
What we're talking about is, in my opinion, one of the things that is often missed and not spoken about when it comes to these syndications, these return on investments, and these IRR's... It's quite easy to say "We bought a property at $60 million, we sold it for $80 million., so therefore we made $20 million." That sounds fantastic, but what was the situation? Was it that you operationally improved the property by increasing the net operating income, and that the fair market valuation increased substantially, and therefore you really did a value-add business plan and created a lot of value for your investors? Or did you just find a good deal at a good price and then you happen to get an above-the-market offer, therefore not giving so much credit to the operator?
To that point, I was in another deal, a different deal now I'm talking about, years ago. They projected about a 20% IRR return. We ended up getting about a 10% annualized return. Here's my simple way of looking at that. This operator more or less bought a good property at a good price, in a good market, at a good time, but they did not execute the business plan the way that they intended to, the way that they told investors they would. In other words, they said, "We're going to buy this, the rents are whatever, $1,000 a month, we're going to move them to $1,300 a month over five years, blah, blah." They really didn't; they got a little ways into the value-add, they ended up selling the property early and exiting out of it, and they really didn't do a lot.
But here's the point - they bought a good asset at a good price, a good market, at a good time; the market was going up. Why? Because interest rates were coming down, cap rates were compressing, it was a growing market, so we ended up making, in my opinion, a 10% return just simply because the market increased. In other words, if interest rates were flat, cap rates were flat, and the market was flat, and no one really moved in or out, and the operator didn't do anything to the property, then nothing would really change the value of that property. So we would have a 0% return if they didn't do anything. But the market bailed us out.
This has been happening, of course, for almost 10 years, if you think about it. The market has been up since 2012, more or less, since kind of when the bulk of the recovery started happening in real estate. Now here we find ourselves in 2022, about 10 years down the road, and again, we've had reduced cap rates, reduced interest rates, and a lot of people needing to rent and own, and we're behind in housing... So market conditions have made a lot of people a lot of money; as they say, a rising tide lifts all ships. What you've got to look at though - I talk a lot about looking at the track record of an operator. You can't just say, "What IRR Have you given your investors?" They say, "Well, 18% historically. " Well, that's awesome, but how did they arrive at the 18%?
Break: [00:08:01] - [00:09:52]
Travis Watts: Here's the metric nobody talks about - what was the net operating income that they actually changed on the property? Let me frame that a different way; that might have been kind of confusing. What I would look at is... No, I'm not going to use any specific examples, just for sake of privacy. Okay, so an operator says, "We have effectively increased the net operating income by 30% on our properties historically." That's the metric you've got to look at because they actually went into the property and they either cut expenses and/or they increased the rents. That effectively changes the net operating income on the property.
I've spoken about this a lot, but just to recap quickly... The net operating income is the primary driver to the value of what someone's willing to pay for a multifamily property, or self-storage, mobile home parks, or whatever. A simple way of looking at it is you've got a property that produces a million dollars per year, let's say, for example. What am I willing to pay you for that million dollars per year in cash flow? Let's say I give you a 20X multiple. In other words, I'll pay you $20 million for that property that produces $1 million per year. What does that give me as a return on investment? It gives me about a 5% annualized return if you run the numbers. if you take 1 million on your calculator and divide by 20 million purchase price, that's a 5% annualized return.
That's realistic, you guys, in today's world. As crazy as that sounds. We're seeing cap rates at 4% and 5%, sometimes 3%. That's how especially institutional investors are valuing multifamily apartments. So when you come in and say you bought that property, $1 million net cash flow, $20 million purchase price - if you can come in and cut expenses and then you can raise the rents over a series of years by actually adding value to your residents and to the property... Let's say that million dollars is now $1.5 million, and you use that same example of valuation, the equity multiple; someone says, "Hey, I'll pay you 20X, whatever your cash flow is." Well, if it's $1.5 million, you just increased the value of that property by $10 million.
They're willing to pay you 30 million for that same property, because it now produces a million and a half per year, not 1 million per year. So that's the metric that you should always be asking for, you should always be looking at. Because think about it - you can apply this to single-family homes. If you had bought a single-family home, almost throwing a dart out there in the US, any city, in 2018, and you are selling it today, you probably made money. But that doesn't mean that you're a smart investor, that doesn't mean that you did anything to the property; that means that the market went up. So you can't rely on markets bailing you out forever, you can't rely on working with a syndication firm that relies on markets bailing them out... Because I've seen it a lot, and it's great to put together your little track record and say, again, we've given investors an 18% return... But what did they actually do to produce it?
Something to keep in mind. I hope you guys found some value out of this episode. I hope the audio held up for us. We'll see you next time on another episode of The Actively Passive Investing Show. Have a Best Ever week, everyone.
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