MODULE 1 UNIT 2

Video 1 Transcript

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Module 1 Unit 2 Video 1 Transcript

DAVID GELTNER: Hi, everyone. Now that you’re familiar with calculating the internal rate
of return of a real estate investment, I would like to show you something useful we can do
with that IRR for the purpose of analyzing a real estate investment.

Recall from your reading notes that the simple holding period return can be broken out into
two components: yield and growth. In a similar manner, the IRR can often be usefully
broken out into the following three components: initial yield, cash flow change, and yield
change.

This process is referred to as IRR Performance Attribution, or “parsing” the IRR into
components that are approximately additive. You can think of the three components, or
attributes, like the sources or causes of the overall investment performance represented
by the IRR.

Why would an investor want to do this type of performance attribution? Different property
investment returns may lean more towards one of the components than the others, even if
the overall IRR is the same. This can help in choosing between alternative investments.
Because the motivations of investors differ, some investors may care more about one
component of the IRR than another. Some investors may be more concerned with the cash
flow they will receive immediately after having made the investment, while other investors
may be more concerned with the long-term income potential of the property. Still, other
investors may be more concerned with the growth of the asset’s value over the long term.

Also, because the components are related to the sources or causes of the overall IRR,
performance attribution can be helpful for diagnosing and analyzing multi-period
investment performance.

The IRR can be computed ex ante or ex post. Answer the following question to review your
understanding of these two terms.

QUESTION: If the IRR is calculated ex post, it is done retrospectively.

True

Correct, well done. If the IRR is calculated ex post, it is done after the investor has
held the asset for a period of time, or even after the asset has been sold.

False

Incorrect. If the IRR is calculated ex post, it is done after the investor has held the
asset for a period of time, or even after the asset had been sold.

DAVID GELTNER: Ex post, the IRR reflects the price paid for a real estate asset, the net
cash flows earned over time, and the price the asset is currently valued at or was sold for.
The IRR therefore indicates how well an investor performed in the following four basic
functions of property-level real estate investment: property selection, finding a property that
is not too expensive, that is priced at a going-in yield that isn’t too high; acquisition
transaction execution, getting the deal done effectively, sometimes at a lower price;

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operational management, that is, managing the property well while it is being held;
disposition or resale transaction execution, which includes finding a good buyer who will
pay a high price, which equates to a low yield, for the property.

Property selection and acquisition transaction execution are particularly related to and
reflected in the initial yield, or IY, component and the yield change, or YC, component.
Operational management is particularly related to and reflected by the cash flow change,
or CFC, and yield change components. Disposition transaction execution is particularly
related to and reflected by the yield change component. Performance attribution can be
used as a diagnostic tool to identify your strengths and weaknesses when it comes to these
functions and to identify the source of returns. This may also be useful ex ante when
considering a property investment. Do the major sources of its projected IRR align with
your strengths and abilities as a property investor?

Let’s look at an example of parsing the IRR.

Now, let’s walk through the mechanics of how we compute the IRR components. Let’s
continue with the simple numerical example of a multi-period property investment that we
looked at previously. Recall that the IRR is calculated as 5.82%, based on the initial capital
cash flow, the operating cash flows, and the terminal capital cash flow.

We now want to separate this IRR of 5.82% into its three major components.

FORMULA: IRR = IY + CFC + YC

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The first component of the IRR you have to identify is the initial yield. The initial yield is the
cash flow yield earned during the first year of the investment, based on the original amount
paid for the investment. This is calculated by dividing the operating cash flow amount in
Year 1 of 50,000 dollars by the investment amount in Year 0 of 1 million dollars, which
gives an initial yield of 5%. Your formula now looks as follows.

FORMULA: IRR = 5.00% + CFC + YC

Now, assume that Year 5’s operating cash flows are projected to be 60,000 dollars. Based
on this, the terminal yield of the asset is calculated as 5.76%, as you divide the cash flow
of 60,000 dollars by the resale price of the asset at the end of Year 4, which you recall is
1,041,012 dollars.

You will use this information to calculate the cash flow change, which is the second
component of the IRR. The cash flow change is the increment in the IRR relative to the
initial yield caused purely by changes in cash flows. To compute this, we first compute
what the IRR would be if the terminal yield remained constant, that is, what the IRR would
be if the terminal capital cash flow reflected a yield of 5% instead of the actual terminal
yield of 5.76%. This gives you a Year 4 capital flow from resale of 1.2 million dollars, which
is 60,000 dollars / 0.05, which would then provide the project with an IRR of 9.23%.

The cash flow change component is now calculated by deducting the initial yield of 5.00%
from the IRR you just calculated of 9.23%. This gives you a cash flow change component
of 4.23%. This component is positive because the cash flow generally or overall grew from
Year 1 to Year 5, even though it didn’t grow every year. Your formula now looks as follows.

FORMULA: IRR = 5.00% + 4.23% + YC

The last component you have to identify is the yield change. Again, we want to measure
the pure effect of just the yield change, without any cash flow change. To do this, you first
calculate what the IRR would have been if the operating cash flows remained constant, but
the cash flow at the end of the period reflected the actual terminal yield of 5.76%. Thus,
instead of the 1,041,012-dollar capital cash flow or reversion in Year 4, it would be 867,510,
which is the 50,000-dollar constant cash flow at the initial rate divided by the actual terminal
yield of 5.76%. This gives you an IRR of 1.77%.

The yield change component of the IRR is, again, only the incremental difference relative
to the initial yield caused purely by the yield change with cash flow held constant. So, we
subtract our 5.00% initial yield from the 1.77% IRR we just computed. This gives you a
yield change component of negative 3.23%. This is a negative percentage, as the yield
going into the investment is smaller than the yield at the end of the investment. The yield
increased from 5.00% to 5.76%, implying a loss of value per dollar of income. Recall that
price is inversely related to yield. Your IRR components formula now looks as follows.

FORMULA: IRR = 5.00% + 4.23% − 3.23%

= 6.00%

This approximately equals the actual total IRR of 5.82%. The slight difference of the actual
IRR relative to the sum of the three components, here a negative 0.18%, is caused by the
interaction of the three pure components together in the overall IRR. We refer to this as

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the interaction effect. It is usually small with typical property investments. In this video, you
learned that the IRR of a real estate investment can often be largely parsed into three
different components, namely initial yield, cash flow change, and yield change. By
separating the IRR into these three components, you can determine which components
contribute more towards the IRR of a specific investment. This information can be used to
help evaluate and gain insight about the investment choices and an investor’s
performance.

Reflecting on what you have learned in this video, how do you think IRR performance
attribution can assist an investor in choosing between competing projects that will
seemingly yield the same total IRR?

If you’d like to go over any of the sections again, just click on the relevant button.

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Tel: +1 224 249 3522 | Email: [email protected] | Website: getsmarter.com

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