## Wednesday, June 17, 2009

### The LTV, IRR, DSCR And ROI: Ensuring Accurate Numbers

The majority of real estate investment and development decisions are numbers driven, but it
is important to realize that not all parties are concerned with the same numbers. Therefore, each party in a given real estate transaction would benefit from a greater understanding of the matrices that are important to the others involved.

For example, when an investor is talking to a lender about a transaction, it may not make sense to discuss internal rate of return (IRR) or equity multiples, but it would be very important to bring up the maximum allowable loan-to-value (LTV) ratio. Or, when a developer is trying to raise equity, the investors may not care much about debt service coverage ratios (DSCRs), but they may be very concerned with the cash-on-cash return, for example.

Consequently, it is important to understand each of these matrices and how they are derived. For many of the more complex calculations, participants may find it easier to use Excel or some other spreadsheet software to calculate these numbers. Please refer to the corresponding figures to learn how to input these formulas into the spreadsheets or otherwise perform the calculations. Equity for real estate investments can come from a number of different sources.

Many small investors and developers raise equity from friends and family or from high-net-worth individuals that they may know. Larger real estate companies may have their own dedicated capital, or they may be partnered with opportunity funds or other institutional investors. Regardless of the source, calculating the performance of each invest-ment is essential, and the three most common matrices used are IRR, cash-on-cash return and equity multiple. Using these matrices enables investors to evaluate the expected performance of each investment and compare it to other possible investments.

The IRR is usually the first number that most institutional equity groups ask for when they are presented with a new real estate investment. For a given investment, the IRR is the discount
rate that makes the net present value of all cashflows equal to zero. When calculating an IRR, you must remember to discount negative cashflows in future years back to time zero at a safe rate. Doing so is necessary because the calculation built into the IRR function in most software will assume that these cashflows are discounted at the IRR. Obviously, this assumption causes investors to set aside insufficient cash to fund these future shortfalls.

It is possible to use the modified modified IRR (MIRR) function on many spreadsheets, but then you must also decide upon a reinvestment rate for future positive cashflows. At the
current time, most institutional real estate investors are still using IRR over MIRR and are typically interested in both un-levered and levered IRRs. The un-levered IRR for a project is
calculated using the cashflows before debt service. Although most investors prefer to use some level of leverage when purchasing properties, the un- levered IRR is still very useful.

Remember that when you leverage an investment, you are adding additional risk. Therefore, an un-levered IRR is closer to a risk-adjusted return than a levered IRR. The levered IRR is calculated using cashflows after loan proceeds and debt service. This figure is usually the number that investors are most concerned with, as it is a good indication of the actual return that they will receive on their investment. Each institution’s criteria for investing are different: Core investors may be happy with levered IRRs in the mid-teens, while value-add and opportunistic investors often look for mid-high twenties or better.

While the IRR displays an investment’s performance over the investment’s entire holding period, many investors are interested in that performance at a given point in time. This performance can be measured as a return on investment (ROI) or cash- on-cash return.

The ROI for a given investment can be measured by subtracting the cost of the investment from the gain from the investment and then dividing the difference by the cost of the investment.

The cash-on-cash return is calculated in a similar way, but it uses cashflows after loan proceeds and debt service. The cash-on-cash return is important to investors who are seeking
current income. Equity investors also want to know how many dollars they are going to receive over the entire holding period for each dollar that they invest. This is often referred to as the equity multiple or holding period return. It is typical for investors to get a minimum
of two times their initial investment back out over time.

From a recent article in:

Commercial Mortgage Insight
August 2008 issue
By Joseph R. CaCCiapaglia