The Private Equity Real Estate Podcast – Show 23
Summary
On this week’s episode, we discuss the topic of evaluating private equity commercial real estate returns with Tony Grosso one of the co-founders and managing partners of First National Realty Partners.
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Announcer:
You’re listening to the Private Equity Real Estate Podcast brought to you by First National Realty Partners, where investors learn from private equity experts and insiders. We share our own real world experiences so you know exactly what it takes to be highly successful at investing in passive commercial real estate opportunities.
Eric Murphy:
Hello, and welcome to the Private Equity Real Estate Podcast, which is brought to you by First National Realty Partners. I’m your host, Eric Murphy, and on this program, we sit down with experts in commercial real estate and we chat about different topics across the commercial real estate landscape.
Eric Murphy:
This week, we are going to get into the topic of evaluating private equity commercial real estate returns, and our guest this week is Tony Grosso, Co-Chairman, Managing Principal and Founder of First National Realty Partners, one of the nation’s leading commercial real estate private equity firms. Tony has been involved in all phases of First National Realty Partners development since its founding.
Eric Murphy:
Tony, good to have you back on the program.
Tony Grosso:
Thank you for having me, pleasure to be here as always.
Eric Murphy:
So today we’re discussing, evaluating private equity commercial real estate returns. And I guess, Tony, to start, why does commercial property valuation matter so much?
Tony Grosso:
Well, if you’re speaking specifically to valuation, I think it’s probably the biggest equation. The biggest number you look at when you’re going into acquiring a piece of commercial real estate, whether it’s land or an office building or retail shopping center, apartment complex, valuation and where you buy the property. We have a saying, you make your money on the buy, and we didn’t coin that but it really is true. Valuation is everything and it sets the direction of how a property deal is going to unfold from a return standpoint.
Tony Grosso:
Just to give you a little anecdotal example, there’s a lot of real estate out there that we look at that we really like, but the valuation is too high. It’s in the stratosphere. So even though it may be great real estate with great fundamentals, for us to make a return that’s acceptable for the risks that we’re taking, you have to hold it for 200 years, and that’s just not going to jive with us.
Tony Grosso:
For other investors that have a mandate that has that long-term a 100 year multi-generational hold, they might go out and they say, “Hey, we don’t care if we make a return on this thing for a hundred years or 60 years.” But it all comes down to valuation. That’s everything.
Eric Murphy:
Well, what are some of the methods that an investor can use to determine the value and measure commercial real estate returns?
Tony Grosso:
The pound for pound return at a real estate level. This is not as a passive investor. This is on the front end from a real estate valuation level. If you’re just out there bidding against other real estate investors, not working with a sponsor or investing in a passive deal, is the cap rate. The cap rate is everything.
Tony Grosso:
Now, if you’re a stock market investor, you may have heard the term PE, or price-to-earnings ratio. What we do in real estate is we kind of flip that on its inverse and we take the net income from a property, which is all of our income leftover after we pay our expenses, but before depreciation, before debt service, and then we divide it by the purchase price and that’s the cap rate. And the reason why cap rate is so important is because it allows you to tell a story of where that property sits in the generic commercial real estate investing landscape.
Tony Grosso:
I’ll give you an example. There are certain markets in this country where the political climate is not as good, where other pieces of property are located. What happens? Cap rates go higher, valuations go down. They get those states, get penalized because the political climate is not as good. Same thing with population growth. If there’s this notion that all of these people are moving to a certain place, that’s great for real estate values. Cap rates are going to be a little bit lower.
Tony Grosso:
If people are blowing out of an area and there’s a mass migration and the political climate is bad because whatever reason and the weather, the people like the weather anymore, work from home, whatever the issue de jure is going on, those cap rates are actually going to go higher and valuations are going to come down. So what the cap rate allows you to do is compare different asset classes, different geographies, different structures and deals, maybe short-term leases, long-term leases, and that gives you a valuation to compare different investment styles.
Eric Murphy:
Are there any limitations when using the cap rate formula?
Tony Grosso:
There are, specifically when you talk about an investment style. Cap rate is not everything. Cap rate is, when it comes to core investments, you want to look at cap rate as a big component, but there’s also a value add deals. So you may not want to run around and say, “Oh, we only buy eight cap rates.” You may say, “Hey, I’ll buy this four cap rate or this zero cap rate. It has no cashflow, but it’s got so much upside. It’s 10% occupied and I’m going to lease it out, and when I’m done with my business plan, it’s going to be worth a 30 cap on what I paid and then I’m going to sell it back into the market at a stabilized cap rate of seven or eight cap.”
Tony Grosso:
So cap rate is not everything. It’s a big equation when you’re comparing apples to apples, and let’s say the core stabilized real estate markets who are looking at stabilized assets in different parts of the country or different product types. But it certainly is not the only equation in commercial real estate, because what really matters is the amount of risk you take on and what your return is. And cap rate is not the definition of your return. It’s what you would earn if you bought a property day one or year one in a bubble with no leverage.
Eric Murphy:
Well, you mentioned the different equations. Let’s talk a little bit about internal rate of return. What is it and how do you calculate it?
Tony Grosso:
Yeah, IRR is a calculation of all the cashflows that come back to you, and the real two ways that you calculate that are from distributions, meaning from on an ongoing basis. So tenants pay rent, we pay our expenses, we retire our debt service and we’re left with cashflow, which some people look at as a return on equity, and so that’s one form of cashflow. And then the other cashflow is at the end of a holding period when you sell or refinance the deal, that’s the other internal rate of return component.
Tony Grosso:
So it’s really a summary of all cashflows based on what you invested in the deal, and it’s done on an annualized basis. So let’s say you make 100% return over the course of five years on your money. If you divide that by five years, your IRR would be 20%. And some people use net present value and all the calculations and whatnot, but that would be a 20% IRR.
Eric Murphy:
What drawbacks might you encounter if you’re just using IRR?
Tony Grosso:
IRR really is the purest way to calculate returns, but it misses the more non-numerical components of real estate, which is just as important as the actual financial component, and that’s risk. And I know that there’s a lot of investors out there today that will analyze deals, IRR versus IRR. So they’ll say, “Okay, this one’s 28% IRR and this one’s only 11% IRR. I’m going to go with the 28%.”
Tony Grosso:
Well, if both of those investments … First of all, when you’re initially investing in a deal it’s all speculation. It’s a business, it’s an underwriting model. It’s a financial model. You could make 28. You could lose. You can make more. And people really need to understand that in real estate, is that everything is just based off of the financial model, but comparing 11% projected IRR to a 28% projected IRR. One situation could be in Venezuela, nobody can finance it. It’s a 0% occupied. There’s all kinds of blight, there’s AK-47s necessarily to collect the rent, and that’s what they’re projecting is the 28% deal.
Tony Grosso:
Whereas 11% deal, maybe it’s a triple AAA credit deal and you’re buying it at an incredible price, which would be an 11 cap rate and you’re going in all cash. So to compare IRRs on deals, you’ve got to look at the total picture, and that’s the real estate fundamentals, the risk profile, the geography, the tax implications. There’s more than just IRR and if I would encourage people that are looking to invest in deals, you have to look at more than IRR because you can’t look at stuff in a vacuum. There’s no guarantee that IRR is even going to be achieved and you have to look at all the factors that go into it.
Eric Murphy:
Yeah, the IRR is paired sometimes with the equity multiple. Can you explain to us how the equity multiple works?
Tony Grosso:
Sure. So equity multiple really is the wealth generation metric when you’re evaluating real estate deals or private equity deals. Basically the equity multiple is if I put in, let’s say $1 into a deal and the sponsor, whoever’s projecting a equity multiple of two, that means that I’m going to put in $1 and over the course of the whole period, that’s going to be turned into two. That’d be a two times equity multiple.
Tony Grosso:
Let’s say another one, a three times equity multiple. I invest $250,000 in this deal, and between a combination of cash distributions and upside, which are the two ways that you get paid in real estate outside of loan paid out and the tax benefits and all that stuff. I put $250,000 in, over the course of the whole period, I get some distributions. And then in year, I don’t know, five, I get my capital back, we sell the property. And when you add all that up, it equates to 750,000. That’s a three times equity multiple. So that’s how that number works. It’s how do you multiply your cash investment and then what does that look like?
Eric Murphy:
All right. Very good explanation. Well, you’re listening to the Private Equity Real Estate Podcast, which is brought to you by First National Realty Partners. A little bit about our sponsors. First National Realty Partners is a rapidly growing commercial real estate private equity firm that owns and operates more than 3 million square feet of real estate throughout the United States with a portfolio valued in excess of $400 million.
Eric Murphy:
First National Realty Partner focuses on expanding its portfolio by acquiring market dominant, well located commercial assets well below replacement costs. First National Realty Partner actively its portfolio through an in-house team compromised to more than 30 full-time real estate professionals focused on acquisitions, property, asset management, leasing, finance, accounting, and investor relations.
Eric Murphy:
You can get in contact with someone at First National Realty Partners by emailing them at info@fnrpusa.com. And our guest today is Managing Principal and Founder of First National Realty Partners, Tony Grosso.
Eric Murphy:
Tony, I want to move on to another metric, cash-on-cash return. How is that calculated?
Tony Grosso:
Sure. Another good one. So your cash-on-cash return is a number traditionally that cashflow-oriented investors utilize to calculate how much return on their equity they’re going to get from a cash distribution standpoint. So let’s just say I invest a million dollars in a deal. After paying all expenses, paying the lender, paying everything off, I’m left with, for the year, let’s say $60,000, and that gets all distributed to me. Okay. That’s a 6% cash-on-cash return. So I invested a million, I got 60 grand back throughout the year in my bank account, that would be a 6% cash-on-cash return.
Tony Grosso:
Another example, let’s say I invest $10 million in a deal and I get a million dollars in distributions throughout the year. That would be a 10% cash-on-cash return. So it’s just the function of what you actually put in the deal and how much it’s producing on an annualized basis.
Eric Murphy:
Are there particular constraints that one might run into if they’re just using cash-on-cash return?
Tony Grosso:
If you’re just investing for cashflow, see, and that’s really a cap rate COC question. Because if you’re going in year one, you want to buy property, in my opinion, and this is just my personal thesis, that there’s better days coming than going. What happens is people get lured into something, and I wrote about this at length, called the Cap Rate Trap, and you could also look at it as the cash-on-cash return trap, where people will look at a piece of real estate and they’ll say, “Oh man, I can buy this thing at a really high cap rate. It’s going to cashflow like crazy. I got to buy. This is a better deal than if I go to a smoking hot market and buy a multifamily property at a lower cap rate.”
Tony Grosso:
The problem with looking at that is the theory is the lower cap rate property has better days ahead. The higher cap rate property, and this is the market telling you this, this is not actually how it plays out, this is the consensus of the market at that point in time, but a higher cap rate property would be out of vogue, where a lower cap rate property is in vogue. So the theory is the lower cap rate property is going to continue to do better as time goes on, maybe it’s more secure, less risk. And the higher cap rate property is out of vogue with the investor in the market and it may trend down.
Tony Grosso:
So you may be buying a big fat cap rate in year one, but the theory is, is because you bought that, unless you’re really making your money in the buy, if you’re just buying the broad market, you’re paying let’s say 10, 11, 12 cap rate. There may be more to that that meets the eye. It may be a blighted area. It may be tremendous amount of vacancy in the area and you’re catching a falling knife. So you’ve got to really, you can’t get just caught up. It’s part of the equation. IRR is everything from a return standpoint, it doesn’t tell the whole picture, because you got to look at risk and whatnot. But cash-on-cash, just looking at that alone is probably not the best solution for investors.
Eric Murphy:
Tony, can you give us a situation where you might recommend one of these measures over another?
Tony Grosso:
Yeah. I mean, you look at a development deal, so you’re buying a piece of raw land. That’s going to have a cap rate of zero. That’s actually negative because it’s losing money because you have to carry the property. That piece of raw land, while it’s not producing anything year one or two or maybe three, that could be the most superior IRR situation compared to maybe two or three other cashflow producing investment, and it should because you’re taking more risk for coming out of the ground. So you can’t compare, let’s say a more opportunistic type of deal, ground up development or a heavy repositioning that doesn’t have cashflow to a cashflow producing deal. Because the theory is, is the reason you’re taking on that risk in that opportunistic scenario is to make a much higher internal rate of return.
Tony Grosso:
But again, everything is built to a cashflow stream. So even that piece of dirt, even that you’re developing into a multi-tenant industrial complex, you’re building it to a proforma cashflow stream and that’s really where the value comes from in commercial real estate. It’s a property’s ability to produce cashflow. The end-user is valuing that property from a cashflow standpoint, whether you like it or not.
Eric Murphy:
If I’m an investor and I’m looking at two similar properties, is there one metric that is maybe more beneficial if I’m trying to compare properties?
Tony Grosso:
I think IRR takes into the debt component and cash-on-cash return takes into the debt component. I think if you’re looking generically across the country, your best measure is probably cap rate from a stabilized product standpoint if you’re looking to invest in deals. But if you’re somebody who’s investing in passive deals and you’re working with a sponsor and it’s what your goals are. If you’re looking to make home runs and make 20% plus IRR, well, probably you’re going to look for a more opportunistic type of situation. Whereas if you’re somebody who needs cashflow, you might want to buy something a little bit lower on the risk curve that produces maybe a little bit less cashflow, but it’s a little bit more stable. So there really is not one way to look at a deal.
Eric Murphy:
Okay. Before I let you go, Tony, what due diligence do you think is important before one makes an investment?
Tony Grosso:
You need three things in a private equity deal to do successful. It’s like a stool, is the way that I … a three legged stool. If one’s too short, you’re going to fall over. You’ve got to be a 10 out of 10 in three things. That’s the deal, the sponsor, and the structure. From a structure standpoint, you got to make sure that the sponsor putting the deal together, its interests are aligned with your interests. Meaning the better you do, the better the sponsor does. That’s called an alignment of interest. That’s one of the three legs of the stool to be successful. You want to have complete alignment of interests between the sponsor and the passive investor. Huge, it’s a big one.
Tony Grosso:
Second thing is the sponsor itself. Are they experienced? Are they talented? Who are the people that work there? What’s their track record? Have they had issues in the past? You really want to do a lot of diligence on who the sponsor is. And then the third thing is the deal itself. You could have a great sponsor. You could have a great aligned interest, but if you buy the wrong property and if you buy the property at the wrong price, it’s very difficult to be successful.
Tony Grosso:
So from a deal standpoint, you’re really, when you’re working with a sponsor, you’re leveraging off of them to do a lot of the granular day-to-day type of due diligence. But from a high-level standpoint, you want to look at every, a lot of the rent roll. You want to look at the market. You want to look at what product type it is. There is a whole exhaustive list of things that you need to do on the deal as well or the fund and the strategy. So that’s it. It’s the sponsor, it’s the structure, and it’s the deal. They’ve got to be 10 out of 10. Those are your due diligence items.
Eric Murphy:
Tony, if someone wants to get in touch with you, how do they do so?
Tony Grosso:
You can email me at agrosso@fnrpusa.com, or go to our website, fnrpusa.com, and we’ve got great educational stuff. We’ve got a blog on there that goes over a lot of these topics and much, much more. So that’s fnrpusa.com.
Eric Murphy:
Fantastic. Tony Grosso, Co-Chairman, Managing Principal and Founder of First National Realty Partners, appreciate you being on the show today.
Tony Grosso:
Pleasure to be with you. Thanks for having me as always, Eric.
Eric Murphy:
My thanks again to our guest today, Tony Grosso, and thank you for listening to the Private Equity Real Estate Podcast brought to you by First National Realty Partners. I’m your host, Eric Murphy, reminding you if you haven’t already, please subscribe to the podcast and rate and review. I’ll talk to you again next week. Thanks for listening.
