Case 010Real assets and private marketsHard
Buy an office building at a 7.5% cap rate on Rs 30 crore of income, with 2% costs, 4% growth, a 55% interest-only loan at 9% and an exit at an 8.0% cap rate after five years. What are the levered IRR and equity multiple, and which input moves the return most?
1The situation
A real estate fund can buy Pashan Business Towers, a leased office building, at a 7.5% cap rate on next year's net operating income of Rs 30 crore, a price of Rs 400 crore. Transaction costs are 2% of the price on the way in and 2% on the way out. Net operating income is expected to grow 4% a year.
A bank will lend 55% of the price, Rs 220 crore, at 9%, interest only, repaid at sale. The fund plans to sell after five years at an 8.0% cap rate on the following year's income. The fund's target for this kind of equity is 13%.
2Your task
Compute the levered IRR and equity multiple, show which input moves the return most, and say whether the fund should do the deal at this price.
Quick check
Roughly what levered IRR does the equity earn?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
A levered IRR of about 10.0% and an equity multiple of 1.55 times, short of the 13% target. The fund puts in Rs 188 crore, collects Rs 10 to 15 crore a year after interest, and gets Rs 227 crore back at sale. The building earns only 9.5% unlevered against a 9% loan, so leverage adds little, and the exit cap rate moves the IRR most. At about Rs 378 crore the deal would clear 13%.
Step 1What do you set up first?
The price and the equity cheque. A cap rateNet operating income divided by property value. A 7.5% cap rate on Rs 30 crore of income means a price of Rs 400 crore. of 7.5% on Rs 30 crore of income is a price of Rs 400 crore; add Rs 8 crore of costs and subtract the Rs 220 crore loan. The fund's equity is Rs 188 crore, and every later cash flow is measured against it. Buying a flat works the same way: the price, plus stamp duty and fees, minus the home loan, is the cash you actually hand over.
Step 2What cash does the equity receive each year and at the end?
Each year the income grows 4% and the interest is fixed at Rs 19.8 crore, so the equity receives Rs 10.2 crore in year one, rising to Rs 13.9 crore in year four. At the end of year five the building sells at 8.0% on year six income of Rs 36.50 crore, Rs 456.2 crore. After 2% costs and repaying the Rs 220 crore loan, the equity receives Rs 227.1 crore from the sale, which is most of its return.
| Year | Net operating income | Interest | Sale less costs and loan | Equity cash flow |
|---|---|---|---|---|
| 0 | (188.0) | |||
| 1 | 30.00 | (19.8) | 10.20 | |
| 2 | 31.20 | (19.8) | 11.40 | |
| 3 | 32.45 | (19.8) | 12.65 | |
| 4 | 33.75 | (19.8) | 13.95 | |
| 5 | 35.10 | (19.8) | 227.1 | 242.42 |
| Received | 290.6 |
Step 3Why does leverage add so little here?
Borrowing helps only when the asset earns more than the debt costs. The building on its own returns 9.5% a year: a 7.5% income yield, plus 4% growth, less the drag of selling at a higher cap rate than you bought and paying costs twice. The loan costs 9%, so each rupee borrowed earns the equity only about half a point, and the levered IRR of 10.0% barely clears the unlevered 9.5%. This is why the loan-to-value line in the tornado is so short: more debt adds risk without adding return.
Step 4Which input moves the IRR most?
Flex each input by a plausible amount and watch the IRR. Half a point on the exit cap rate swings the IRR by 4.5 points, more than a full point of income growth, 4.0 points. The exit price is five years of growth capitalised at one rate, and it lands on the equity after a fixed loan has been repaid, so a small change in the cap rate becomes a large change in what the equity receives.
Step 5Should the fund buy it?
Not at Rs 400 crore. The base case earns 10.0% against a 13% target, and it needs either a lower exit cap rate or faster growth than assumed to get there, which is paying today for optimism. Solving for the price that gives 13% on the same assumptions gives about Rs 378 crore, a cap rate of 7.9%. That is the number to take into the negotiation, along with the lease expiry profile, which decides how safe the 4% growth really is.
Where candidates lose it
The usual loss is capitalising the wrong year's income at exit, or forgetting the 2% sale costs, which quietly adds half a point of IRR. The buyer in year five pays for the income it will receive, year six, and the seller pays costs too.
The second is assuming leverage always raises returns. It raises them only by the spread of the asset's return over the cost of debt; here that spread is about half a point, so the loan mainly adds risk.
What the interviewer asks next
- The bank offers a 65% loan at 9.5%. Would you take it?
- Half the leases expire in year three. How would you change the model?
- What exit cap rate makes the equity IRR equal the 9% cost of debt?
- How would a fee and carried interest waterfall change what the fund's investors receive?
Asked at Carlyle Group, Asset Management, Washington, 2015 (Wall Street Oasis): Case study was a typical PE real estate acquisition with no waterfall analysis.
Company names and figures are illustrative.