Myths of Measure - Posted by ray@lcorn
Posted by ray@lcorn on June 13, 2009 at 11:46:31:
John,
The best application I know that utilizes the full spectrum of assumptions and variables in calculating returns is the RealData program, but the product is much more than a return calculator. It creates APOD analysis and at least ten other functions. It runs as an Excel overlay and available in several levels of sophistication (and cost). All are excellent products and available on the Real Data site at www.realdata.com. (I receive no compensation for recommending this product. I have been a paying customer for over ten years and speak as a satisfied user.)
However, be aware that, as Einstein once noted, “not everything that matters can be measured, and not everything that is measured matters.”
Applied to commercial real estate, years of frustration in the use of IRR and MIRR projections that were almost always proven wrong in real life (sometimes spectacularly so) led me to refer to them as “Myths of Measure”.
At the risk of being pilloried by my peers, I went to great length in my book to explain why IRR and MIRR calculations are not appropriate for real estate investments. These calculations are designed as decision-making tools between competing projects, typically a manufacturing setting, to evaluate the differing capital investment amounts and eventual return of producing products in a controlled setting, with comparable risk and costs of capital. Real estate is anything but that.
The real estate industry is extremely fond of promoting a magic bullet approach to valuation and the comparative grading of investment choices, the one formula that does it all for you. Just plug in all the inputs, click the button, and voila!, it spits out the number that makes the decision for you. I wish that it were so�
The problem, as with most �magic bullets�, is in the assumptions. I’ll spare you the details from the book�s Valuation chapter (and a 30-page appendix by Dr. Pamela Peterson, Ph.D., who explains better than I can about the proper use of capital budgeting techniques in real estate), and cut to the bottom line: In trying to evaluate competing real estate projects they will by definition be in separate locations, perhaps differing types and markets, and subject to different finance structures and most importantly, different risk profiles, and require different levels of assumption. By definition, assumptions are subject to error.
The assumptions needed for MIRR calculations will be, at minimum, the cost of equity and debt capital; the operating cash flows for several years of operation which will in turn rely on revenue and expense assumptions, some of which are completely outside your control (e.g. utilities and taxes); and the exit value based on a future cost of capital and desired return by an unknown buyer in unknown market conditions. That�s a lot of assuming, eh?
So I know before I start that I am going to make mistakes in the assumptions. But the real problem is that if I am going through this whole exercise for the purpose of deciding between competing mutually exclusive investments (i.e. if I do one I can�t do the other, so which is best?), then unless I make the same mistakes in my assumptions for each project, with the same degree of error, then the resulting comparison on an IRR or MIRR basis is worthless. So why bother?
The question then becomes: what is the best way to evaluate competing projects for our investment dollars?
My answer is to focus on the valuation of the asset at three specific times in the life of an asset:
- At Acquisition, based on the first-year projected operating performance with the finance terms specific to the borrower and the project and the buyer�s operational practices (e.g. fee mgmt vs. self-mgmt, improvement plans, etc.). This is known as the “going-in” cash-on-cash return or ROI (Return on Investment. The valuation will be a product of the derived cap rate that provides for your desired return (see my article “What’s it Worth…” at http://www.creonline.com/articles/art-216.html) which provides the risk premium for the project�s unique attributes and potential.
It�s not too hard to get an accurate projection (within 5% or so) for the first year of operation using current rent roll and expenses as a starting point. I usually project three full years of operation using the most recent 12 months as a base year. That gives me a good idea of the total performance leading up to the next point of valuation;
- At Stabilization, i.e. the point at which the investment plan is in place and the property is at a point of stabilized operations, usually 2 to 3 years after acquisition. The valuation at this point reveals the Return on Equity (ROE), which is the information needed to perform a sell/hold/refinance analysis.
This is my first look at an exit strategy for a deal. With the information from #1 and the stabilized value I can make an informed decision between competing projects as to how well they fit my investment criteria, risk exposure, and time horizon. It also gives me an idea of what I will be dealing with incase the unexpected happens, which is the next point of valuation;
- At Disposition. This is perhaps the most critical valuation of all because it determines your overall returns for the specific asset, and might not always be driven by purely market or asset timing factors. The "Three “Ds”, death, divorce and dissolution often triggers the sell decision in spite of adverse market conditions. This valuation can be used to influence the selling structure, tax attributes and various capital management issues. It is performed the same way as #1; using the derived cap rate for current market conditions regarding investor return expectations and capital costs.
Used properly these three measures offer the most accurate representation of value and returns at the appropriate times, using data that requires the least amount of assumption (i.e. guesswork), and yields the most useful results for the question at hand at the time. It�s not one number, and it�s not perfect. But after almost 30 years in this business I can tell you that nothing else is either!
My two cents,
ray