Did RE Metrics Fail the Industry?

Much has been said regarding the economic downturn and its hard-hitting subsequent effects on the commercial real estate industry.  When economic forces such as unemployment, consumer spending, and housing all converge negatively on us, most sectors of income producing real estate were hit hard.  But why did we not see this coming?  Or maybe the better question is: Why were we not better prepared for this? After all, real estate is cyclical and the good times could not have lasted forever. While real estate metrics like cap rates, cash on cash return and price per pound are all very simple, yet static tools, why did the more diverse and complex metrics like internal rate of return, specifically designed to take time and market fluctuations into account, seem to fail us?

While this is a broad based question with no scientific answer, first we have to address the limitations of each metric.  Cap rates for example are static measurement os the yield of a property’s performance at a given moment in time.  While most real estate practitioners use an assumed cap rate (perhaps based on recent comparable sales of like properties) to establish the value of the property based on the current NOI of that property, cap rates can and will sway with the wind.  A property’s NOI may remain constant but due to external market drivers, the cap rate my rise or fall, having nothing to do with the property itself. Therefore, while cap rates are the most commonly used metric for their simplicity, they probably are one fo the worst metrics to use.

Cash on cash return is a very basic way to measure return by dividing the cash you receive from a real estate investment (cash flow) divided by the cash (equity) you put into the deal.  This metric is also somewhat faulty because while cash flow is measurable, equity is much harder to determine.  Why?  Overtime, assuming you have a loan on a property, you are paying down the principle balance of that loan.  By nature, this increases your equity in the deal (unless of course your loan is interest only).  You could therefore argue that because you are “paying” off the loan, those payments are essentially an additional equity investment (in addition to the down payment when you acquired the asset) to the property.  But, based on what your amortization schedule and interest rate looks like, the actual gains in “equity” will be all over the place, making it a very convoluted way to figure out how much actual “cash” you have “in the actual deal.  Furthermore, as cap rates and values fluctuate, so will your “equity” or “cash in a deal” figure based on whether cap rates and values are shrinking or growing.

Internal rate of return is a complex way of taking time and assumptions into account when attempting to value a property’s performance.  IRR assumes that there will be a predefined time over which you operate the asset and an assumed exit price at which you sell the asset.  Also taken into account are various other assumptions including probability of lease renewals, what future rents and operating expenses will be, as well as the capital expenditure budgets of the asset over the assumed hold period.  IRR takes all of that information, spits out a series of expected future cash flows, and then discounts those cash flows so that the net present value of them cumulatively is equal to zero, after reversion of equity (after you get your money back from your initial investment in  the property).  The big issue with IRR?  Assumptions.  “To assume makes an ass out of u and me,” and boy did we learn the truth in that adage.  When people make poor assumptions, they get poor results.  Or better yet, “garbage in equals garbage out.”  Many analysts and investors assumed that they could increase income and control expenses indefinitely (or at least way better than the next guy) and their egos lead to their hubris.

At the end of the day, as any tried and true old school developer will tell you, the best metric to use, has been, and always will be price per pound.  While it doesn’t tell you a lot of information, and it doesn’t attempt to predict the future, the one thing it will tell you is if you have paid too much for an investment, regardless of the current performance of that asset.  If you are able to buy or develop a property at a low enough cost basis, the asset should retain its value much better over time regardless of where you find yourself int he real estate cycle.  This may be the best way to insulate yourself from disaster.  While you will still have to pay careful attention to leverage, operating costs, and how to attract and retain tenants, if you pay too much for a building, there is simply no way to overcome that in the long run.

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