Syndication: Common Financial Metrics and Key Terms to Understand
On every deal we syndicate or review there are financial numbers and metrics that are common. I also get plenty of questions from investors on them. I’m going to run through some of the ones that I think are important, not getting too bogged down but staying at a level that I think most new investors will get a better understanding.
The Multiple – This is a popular and easy metric to understand. If I invest $100,000 and it grows to $200,000 (including distributions and sale profits) then it’s a 2x (double my investment). If it grows to $193,000, then it’s a 1.93x. The higher the better the return. Most of the deals we review are for a typical 5 year hold period.
Cash on Cash Return – A rate of return often used to determine the cash income on the investment. If you invested $100,000 and the investment returned $8,000 to you in one year, your cash on cash return is 8%. This simple equation is determined by taking the annual dollar income return divided by total amount of investment.
IRR (Internal Rate of Return) – The rate of return that would make the present value of future cash flows plus the final market value of an investment opportunity equal the current market price of the investment. Say what? This one is sometimes the most difficult to explain but a more sophisticated measure of return. The higher the projects IRR the more desirable it is to undertake the project. The IRR is often a good investor metric to compare similar projects with different or varying pay out streams. Investors that get more money early in the life cycle will have a higher IRR than one that pays off only with a sale in say 5 years. If you want to calculate IRR, simply use an excel spreadsheet IRR function key. Here’s a short video on how to calculate it: https://www.youtube.com/watch?v=Ug74NbL81CE
Average Annual Return – An annualized total return is the geometric average amount of money earned by an investment each year over a given period. It is calculated as a geometric average to show what an investor would earn over a set time period if the annual return was compounded. Here’s an example: The investment earned $275,000 over 4 years. Divide that number by the 4 years equals $68,750 as an average annual return. Divide $68,750 by the initial investment amount of $800,000 to calculate the average rate of return of 8.59%. Average annual returns are typically higher than IRR in the deals we review because a larger portion of gains are typically at sale, say 5 years out in our model hence the IRR which rewards more money coming to the investor earlier in the cycle is impacted negatively. I just think time value of money when I think of IRR. Would you rather have a $1 today or in 5 years ? Today !
DSCR (Debt Service Coverage Ratio) is the multiple of cash flow available to meet annual interest and principal payments on debt. In other words, if my Net Income (revenue minus expenses) is $500,000 but my debt service (not considered an above the line expense) is $500,000 then the DSCR is 1.0, and the project is breaking even. Nothing left for the investors or for a rainy day outside of reserves. Banks require 1.2 and we like to see deals at 1.3 and higher.
Preferred Return - (not a guarantee) but the next best thing for investors. The preferred return or “pref” is a return to a limited partner in an investment syndication that is paid first before the general partner gets paid their share of distributions or profits at sale. Typical preferred returns on apartments and self-storage deals are 7%-8% with mobile home parks are in the 8-10%. Preferred returns should be cumulative and accrue to investors each year if the investment falls short of the target. Deals are usually structured to have this be an annual target for the investment hold period. So, an 8% preferred return over a 5-year hold period would mean investors are targeted to be paid up to 8% each year over that time span. If the investment earns 6% in one year, then the following year the new pref target is 10% (8% target plus 2% catch up from prior year) and so on until the investor is caught up. That is cumulative and accrues to investor and should be paid before general partners get their split on the cash flow or capital events like refinances or sales. That is why we think its so important for investors to see this in the deal.
Split – the percentage of distributions from operations and profits from capital events are split between the limited partner (investor) and the general partner in the syndicate deal. Splits are common in the syndication business. Typical split would be 70% payout to limited partners (investors) and 30% to the general partners after the 8% preferred return is paid to investors.
Waterfall – sometimes we see this in deals especially if they are projecting a healthy return. Syndicates will mark a waterfall (hurdle) where they are looking to receive more of the profits after a certain return is achieved. At that hurdle, the split changes to say 60/40 or 50/50 about a certain return metric like an IRR.
Cap Rate (Capitalization Rate) – the rate of return on the expected income that the property will generate if purchased for all cash. Ex. A 6 (6%) cap should generate $60K in income to the owner who purchased a $1M apartment all cash. When acquiring income property, the higher the cap rate theoretically the higher the return and when selling a property, you want a lower cap rate. A higher cap rate implies a lower price and a lower cap rate implies a higher price. If you took the NOI (Net Operating Income) of a property and divided it by the Fair Market Value (FMV), you would get the cap rate. Conversely if you divided the NOI by the cap rate, you get the FMV of the property. Cap rates move and are influenced by several factors including demand for the asset (lowers cap rates) and increase in interest rates (increases cap rates) to name some of the more important influencers.
Reversion Cap – When you review deals, you will often see an entry cap rate (usually based on the T-3, trailing 3 months of operations before purchase) and a reversion cap, which is the cap rate the syndicate is targeting at exit. You want the pro forma to be conservative and we see .50 basis points higher at exit than entry on the investment but the higher the reversion cap from the entry cap the more conservative the outlook as higher cap rates reduce the FMV of the investment at sale. If you see an exit at the same or lower in the pro forma, seriously question that because its not being conservative. If it happens, great, but modeling should be done with higher exits than entry since it negatively impacts FMV all things being equal.
Sensitivity Analysis – shows the impact to the financial model / investor returns if rents, occupancy, cap rates and interest rates change. It’s important to look at worst case scenarios to see if the business can still be profitable under some of the most challenging times. I like to look at 2009 data on occupancy for instance in a given submarket we’re investing in to see how a similar scenario would impact the property. Not all syndicates do it but you should request to see it as most good ones will have done it already.
Expense Ratio – Typical apartment deals run at about a 50% expense ratio as a percentage of total revenue. That’s the starting point. If we see an apartment running higher than that it may be an opportunity. If running less than that, it’s considered more efficient.
Property Management Fee vs Asset Management Fee – The property management fee is the fee the property management charges to manage the day to day operations of the business. The fee comes out of the operations and is treated as an expense. The asset management fee is typically a separate below the NOI line number that the sponsor/operator charges the investor for overseeing the investment project and ensuring the business plan gets executed. Property management fee is typically about 3% with apartments and the asset management fee we see most often is about 2%. The asset management fee should be a fee that the operator takes when business is performing but can be deferred when times are more challenging that is why it’s a below the NOI number.
Knowing these terms will go a long way in helping you understand how to analyze and compare syndication deals.