Our Over Reliance On IRR and How It’s Costing Us

Over the past two years being an equity broker, I was always struck by the aggressive capital stacks sponsors were using.

Floating rate bridge debt up to 80% of cost.

Preferred equity on top of that.

An extremely exposed group of LP’s who probably didn’t realize how subordinated they had become. (When LP’s invest in deals with high leverage, they increase their risk of losing principal. Because lenders get paid back before investors, a bigger loan amount means that investors are “further behind” in line. If a deal ends up being sold for a loss of 20%, having 80% leverage would result in investors losing all of their principal. If the same deal was levered to 60%, the investors would only lose half of their principal.)

I’d question the sponsors about this aggressiveness.

“The property is 99% occupied. Granted it needs work, and rents are low, but wouldn’t it be safer to use fixed rate agency financing on this deal?”

And the response was always the same: “The IRR would be too low. I will not be able to get investors interested in the deal.”

They were telling the truth.

Trying to buy deals with fixed rate financing these past few years, when underwriting properly, consistently showed a much lower IRR than deals with floating rate bridge debt.

And investors were always looking with deals sporting a high IRR. For many investors, that’s all they looked at, and they did not understand the risks they were exposing themselves to.

But That’s the problem with using the IRR (exclusively).

The IRR tells an investor nothing about the risks inherent in a deal.

In fact, the IRR typically goes up when the deal is levered higher and higher. Meaning, the IRR goes up when the deal is more risky. (IRR is highly influenced by the amount of equity in the deal, the hold period that is proposed, and the sale price that is projected. Engineering a deal so that equity required is minimal would usually end up with a significantly higher IRR. To an extreme, if a deal required NO equity, the IRR would be infinity…)

It would be nice to get to a place where investors focused on downside protection. It would be nice if the IRR was dropped as the most important metric to analyze. I personally barely look at the IRR. On any deal we get pitched.

By focusing on downside protection, we focus on all the possible ways one could lose money on a deal. Only once we are comfortable with the level of risk involved in a transaction, do we start looking at all the things may go right (like achieving a high IRR).

If the basis is good, and the stabilized yield is high, the IRR should work itself out… That’s our way of looking at things.

A little more focus on downside protection on part of the investor community at large would give sponsors the ability to structure their deals safely, and still know that the investors will be there.


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