Fund level IRR

[Anonymous]

Hi guys,

When I was working in real estate fund accounting we used to put together IRR calculations for our investors. The IRR would always use the XIRR function, but would also take into account the current fair value of the fund assets at that point in time. Similarly, in the examples of IRR that are usually presented, the IRR typically includes the reversion of the property. I always thought that IRR was as of a point in time so I never understood why the calculation included the FV of the fund assets. I can only assume that the calculation was supposed to represent the total potential IRR if the fund was completely unwound, and the calculation was not the “actual” IRR.

Do you need to consider the FV or cash flow from reversion at exit when calculating the IRR at a given point in time?

For example:

If I have a building and I am going to exit my position after 10 years, should I be including the estimated reversion price of the building (or fair value of the asset if it’s a fund) in the year 5 IRR calculation?

[Spencer Burton]

Hi bfarbowitz,

We dropped the ball on answering this promptly – sorry for that! This one slipped through the cracks on a busy weekend.

To your question.

I think course 3 will more fully answer this question. But I’ll make two points on this topic and then answer your question.

First, a quick primer on the real estate DCF. The real estate DCF consists of three types of cash flows: ‘Investment Cash Flow’, ‘Operating Cash Flow’, and ‘Reversion Cash Flow’. Without those three cash flows, you cannot properly calculate returns such as IRR. To better understand the concept, think of the real estate DCF in terms of a bond. A bond that yields 10% consists of the following cash flow:

1) Bond purchase (i.e. Investment Cash Flow)
2) Coupon payments paid regularly over the term of the bond at 10% of the face value of the bond (i.e. Operating Cash Flow)
3) Repayment of bond at maturity (i.e. Reversion Cash Flow)

To properly calculate the yield, you would need all three cash flows in your analysis.

Which leads me to my second point, which is remembering the key difference between Finance vs Accounting. Accounting is backward looking (i.e. Actual) while Finance is forward looking (i.e. Forecast). Real estate financial modeling is about forecasting the future. All of your analysis is generally forward-looking, even if you rely on the past for assumptions.

So in your DCF, your reversion value – synonymous with that ‘repayment of bond at maturity’ – is essential to calculating returns. Even if you intend to hold an asset (or fund) indefinitely, there must be a reversion value at the end of any analysis period. That reversion value is what you believe you could reasonably sell the asset for at the end of the analysis period, irrespective of whether you plan to sell the asset or not.

So to your question:

“Do you need to consider the FV or cash flow from reversion at exit when calculating the IRR at a given point in time?

For example: If I have a building and I am going to exit my position after 10 years, should I be including the estimated reversion price of the building (or fair value of the asset if it’s a fund) in the year 5 IRR calculation?”

Yes. If you want to calculate the IRR in year five, you would run a five-year DCF. That five year DCF would include a reversion value at the end of year five. And that value would be what you forecast the asset to be worth at that point.

Your DCF would look something like this:

Year 0 – Investment Cash Flow
Year 1 – Operating Cash Flow
Year 2 – Operating Cash Flow
Year 3 – Operating Cash Flow
Year 4 – Operating Cash Flow
Year 5 – Operating Cash Flow + Reversion Cash Flow

And your IRR calculation, assuming annual periods, would then be an IRR calc of those six net cash flows.

Thanks again for the great question!

Spencer

[Anonymous]

Spencer,

I had an interesting question come up at work today. We are reviewing an IRR calculation for a client and they asked us which days they should use for their contribution / distributions. The Bank statements they provided appear to be at the Holding company level. So on day 1 you see contributions in from investors. On day 10 you see a cash flow out to purchase the property. As time progresses you see more cash outflow from the Holding company and eventually this flips to cash inflows. I wanted to know if i was looking at this the right way:

If you are calculating IRR at the property/investment level, then a cash flow out of the HoldCo = a contribution (example: to buy the property, make a capital call, etc.). Cash flows in to the HoldCo = distribution from the property.

If you are calculating IRR based on the Holdco (or even fund level) then the calculation needs to be based on the day an investor made a contribution and they day they received a distribution, and what the Holdco did with that money in the meantime, not really relevant (whether they put the money to use or if it’s just sitting in the bank because no activity would represent an opportunity cost).

Please let me know your thoughts. I’m glad something like this came up while I still have access to the forums. I’m well behind on the classes.

Regards,

Ben

[Spencer Burton]

Hi Ben,

A really interesting question, and admittedly I’m not an expert in fund-level accounting. I live in the world of future forecast analysis, while guys on the accounting side are much more intimately involved in situations like the one you describe. With that said, I’ve had some exposure to calculating actual investor returns on real estate fund investments, so I’ll offer my two cents with the caveat that I can’t speak to whether my limited experience is representative of industry standard or not.

First to your question of whether what the Holdco does with the investor’s capital is relevant to the investor’s IRR. The answer is no, it does not matter. All that matters in calculating the investor’s IRR is what did the investor contribute and when, and what was distributed to the investor and when.

Next, in terms of how to calculate the investor’s IRR, I’ve seen this done two ways. The first method is to book the investor cash flow, whether a contribution or a distribution, in the actual day the cash flow occurred. This would be the most accurate, since you would be calculating the IRR based on the actual day the investor cash flow occured. In your Excel IRR calculation, you would than have custom periods with each period representing the actual day of the investor cash flow.

So for instance in Excel, you would have a date header row and a investor cash flow row. Starting from the first contribution, you would create a period for that cash flow, enter the date, and enter the contribution as a negative value. The next period would be the date of the next cash flow, if a distribution the cash flow would be positive, if a contribution it would be a negative. You would continue adding periods for each subsequent cash flow until all investor cash flows, with their cooresponding dates, have been logged.

Next, you would calculate the IRR using Excel’s XIRR function, using the date header row and the cash flow row.

Let me know if this first concept isn’t clear and I’ll put together a quick Excel example for you.

The second method I’ve seen makes for simpler accounting but is slightly less accurate. I’ve seen firms book all investor cash flows as of the last day of the month. Then, regardless of the day of the month when the investor cash flow occurred, it would be assumed to have occurred on the last day. This has the benefit of simplifying the process, and there are probably some other accounting reasons/benefits to doing it this way but I’m not qualified to really comment on that.

The IRR calculation using this method would also be calculated using the XIRR function with the dates and cash flows, but the dates would be consistent from one month to the next rather than irregular. The difference in IRR between the two methods would be nominal, but the first method does have the benefit of being more accurate.

Thanks again for the great question!

Spencer

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