In Part I, we discussed how to create P&L for the previously mentioned office building, calculate its cash flows, and examine its debt service. In Part II, we are going to calculate its unlevered & levered IRR and conduct sensitivity analysis to further assess its risk and profitability.
What is IRR?
Internal rate of return (IRR) is a financial metric used to measure the profitability of an investment over a specific period and is expressed as a percentage. A good way to think about IRR is that it is the discount rate – or interest rate – that makes the net present value (NPV) of the cash flows you receive equal to zero.
Unlevered IRR & Cash-on-Cash Multiple
Unlevered IRR is the IRR without taking financing into account. This is as if you bought a property in all cash, which would generally generate a lower return on invested capital. While the return is lower, there is theoretically less risk as the investor retains 100% of their equity in the property. Therefore, when we calculate unlevered IRR, we need to use the cash flows that are available to all investors. The target unlevered IRR on a real estate deal, or the target IRR without the use of debt, will generally fall somewhere 6% ~ 11%. The unlevered IRR in this scenario is 8.62%, showing the project's high profitability before debt.
The Cash-on-Cash multiple evaluates how much cash an investor can get back in comparison to their initial investment. Cash-on-Cash multiple of 1.45x indicates the return can cover the initial investment.
Levered IRR & Cash-on-Cash Multiple
Leveraged IRR is the expected rate of return on an investment that takes into account any debt or leverage that was used to finance the business. As a result, all debt service is paid off first with the project's cash flows. Therefore, we must use the cash flows that are solely available to equity investors when calculating levered IRR. A good levered IRR should typically be more than 15%. With a leveraged IRR of 15.85%, this project offers excellent profitability after debt.
Sensitivity Analysis
Sensitivity analysis determines how different values of an independent variable affect a particular dependent variable under a given set of assumptions. In other words, sensitivity analyses study how various sources of uncertainty in a mathematical model contribute to the model's overall uncertainty. In order to determine which scenarios are most likely to occur, I often study thorough market research before conducting sensitivity analysis.
According to CBRE “Orange County Office Figures Q1 2023”:
· Class A vacancy rates have shifted upward to 16.3% from 14.9% logged just ninety days earlier. Overall vacancy rates have shifted dramatically upward as well to 14.3M sq. ft.
· As the cost of materials and labour have increased, total sq. ft. under construction throughout the county have decreased 795,075 sq. ft. to a single Irvine Spectrum office park with phased development at 258,509 sq. ft. to 1,053,584 sq. ft. in Q1-2022.
· The Orange County office market lease volume experienced a 12.3% drop from Q4-2022 activity.
· Asking lease rates for Orange County office space in Q1 2023 registered at $32.11 a square foot on an annual basis.
This year has seen a collapse in the US office market, and the outlook is still ominous. In this case study, I therefore assume that the stabilised vacancy rate will increase to 16% and the stabilised yearly rent will decrease to 35psf. The sensitivity analysis table indicates that the levered IRR will probably decrease to 6.65%.
Usually, A cap rate above 7% may be perceived as a riskier investment. 7.5% cap rate is thought to be fair in this situation. Because of the declining rent and rising vacancy rate, it is anticipated that the NOI will decline to roughly $6 million with an IRR ranging from 9.67% to 11.79%.
The project's levered IRR is very likely to go below 15% based on the market environment and sensitivity analysis, indicating a significant risk even though the financial model predicts great profitability.
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