The Value of Today

My dog Murphy is a two-year-old bearded collie with the calmest, sweetest disposition of any dog I have ever met. He’d be perfect if not for the fact that he thinks the basement is his personal relief zone—a habit we’ve been unable to break even with bribes of bacon.

I have had several dogs in my life. I grew up with a standard poodle named Schatzie, who was Murphy’s polar opposite in disposition (I had to put on a denim jacket and gloves to control him). My other dog of note was Timber, a pure-bred wolf that lived at my father’s house in the woods near Pound Ridge, New York. As he was, in fact, a wolf, he was a little intimidating, particularly when he would put his paws on your shoulders, look you in the eye and give you a lick.

Given their total loyalty and love without asking for much in return, dogs are perhaps the greatest things in the world for kids. But there is a downside to them: They die young. This got me thinking about where Murphy would be 10 years from now, how my life might be different then, and whether I am focused too much on tomorrow and not enough on today.

As a commercial real estate professional, I have spent most of my career thinking about tomorrow and how to appropriately underwrite the changes that will come. Now that I am in research, I pretty much do it full time. There are lot of ways that we as real estate professionals determine today’s value, including comparable sales, Broker Opinions of Value (BOVs) and appraisals. There aren’t a lot of easy ways to determine tomorrow’s values.

But even today’s “spot” market value is now in flux as the rapid rise in interest rates has put significant stress on the lending markets and materially increased the incidents of re-trades. Estimates of today’s value are affected by the dreaded terminal value estimate and its master Internal Rate of Return (IRR).

I’m not a big believer in IRR as the main metric we use to determine value. It is disproportionately based on a guess about one’s exit cap rate and I prefer to judge value by what can be controlled (the performance of the asset during the hold period) vs. what cannot (capital markets conditions that drive cap rates/multiples). As I make this argument regularly in forums of large investment managers, I know that I am not alone in this opinion.

For some of the most sophisticated investors in the world, the most common way to determine the exit cap rate is to add 50 to 75 bps to the going-in cap rate assumption. I’d like to say this is a bad technique, but it is no worse than using other means, including yield curves and estimates of future capital market conditions. The relationship between cap rates and interest rates is complicated and can be influenced by numerous factors that are largely out of our control, notably the amount of foreign capital entering or leaving a market. Maybe I’m just bitter, as I and most economists have incorrectly predicted for the past seven years that interest rates would increase.

Old-school metrics like cash-on-cash return are undervalued, and our ability to guess the whims of the global capital markets in the future through terminal value or cap rate is overvalued. If an asset manager does a killer job turning around an asset, leasing it up, increasing NOI by 25% and then interest rates spike by 200 bps and the overall return is flat, that asset manager isn’t going to get paid for the real value they added. Similarly, if you buy an asset, do nothing, but ride a cap rate spike downward through the influx of new foreign capital, you are a hero and paid accordingly.     

Perhaps the best answer is for investors to allocate their capital to different managers using different styles. The problem is that so many of our industry benchmarks are designed around IRR-based overall return metrics. Shifting to a new benchmark and fee or compensation structure to match would require some serious industry coordination and a lot of time as existing fund structures are unlikely to be modified or unwound. In short, we are probably stuck with IRR for quite some time and a disproportionate amount of our worth will be gauged on factors that are largely out of our control. But understanding IRR’s limitations as an analytical tool is a step in the right direction.

I spent a lot of time on the road in 2016, and now in late December I am going to pause and not worry about tomorrow for the moment. I will enjoy today with my dog Murphy sleeping at my feet and certainly not dreaming about exit cap rates (or bacon). During this holiday season, I hope all of you have time to do the same. Thank you for reading my blogs in 2016.  

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