A 347% IRR. Here's what actually created it.

Hi {{first_name | there}},

Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.

When reviewing an operator's track record, here's an essential due diligence question:

What portion of a sold deal's property-level appreciation came from net operating income ("NOI") growth versus cap rate compression?

CRE value is driven primarily by two things: NOI growth and the cap rate buyers are willing to pay.

But neither tells the whole story: NOI growth can come from operator execution or simply rising market rents, and a lower exit cap rate might reflect market shifts, property quality, or a great purchase price.

This diligence question matters because the CRE market was unusually strong from 2011-2022, and many operators did well then because of market conditions, not excellence.

In 2020, a property we invested in generated a 347% project-level IRR and a 3.4x multiple on invested capital in ten months.* Let's break down what actually created that result.

In January 2020, Paul and I flew to Louisville, KY to walk a 311-lot manufactured home community with one of our operating partners.

They sourced it off-market through a five-person acquisitions team (basically in-house brokerage) that had been cold-calling mom-and-pop owners since 2014, with each person making 50-100 calls a day.

The property's owner had passed away years earlier; his wife lived several states away, and she had not visited the property since. The wife did not want to deal with a broker and wanted a quick cash closing.

The acquisition closed in February 2020 for $7.1 million, all cash, at a 6.5% cap rate on in-place NOI. The property was roughly 81% occupied. A month later, they placed Fannie Mae debt at roughly 51% LTV. 

In December 2020 (ten months later), they sold it for $15 million.

Five days after closing at $7.1 million, our operator received an unsolicited offer for $9.5 million.

They turned it down without countering.

I was a bit surprised they would decline an offer $2.4 million above what they'd paid less than a week earlier. They believed the property could be worth as much as $13 million after executing their value-add strategy over the next three years.

Buying below what the market is willing to pay is a source of return in itself.

The favorable basis came from sourcing. Years of cold-calling owners helped them find a truly off-market deal like this.

Annualized NOI went from $464,031 at acquisition to $865,381 at sale. An increase of 86.5%.

NOI growth isn't automatically evidence of operator skill. Market rents can rise on their own. Why did NOI increase here?

The operator identified three opportunities:

1. Rents. Monthly lot rents averaged $320 and appeared to be substantially below market. They raised rents to $375. Across roughly 252 occupied lots, that's about $166,000 of additional annual revenue.

2. Utilities. The owner paid water and sewer while local competitors billed residents separately, which typically reduces overall water usage. The operator metered each home and passed those costs through, adding $144,094 to annual NOI.

3. Filling Vacant Lots. Roughly 50 lots were vacant. The plan was to buy and install homes to fill them, but the property sold before they got to it. Occupancy was still roughly 81% at sale.

Those two initiatives explain most of the NOI growth. The rest came from other operating improvements.

Commercial property value is NOI divided by a cap rate. The cap rate went from ~6.5% at purchase to ~5.8% at sale. 

Had the exit cap rate stayed the same as the purchase cap rate, higher NOI alone would have meant a $13.3 million value; the property sold for $15 million.

So of the $7.9 million increase in value, roughly $6.2 million is explained by NOI growth before giving any credit to the market. On that framing, the remaining roughly $1.7 million came from valuing the higher income at a lower cap rate.

There's no single correct way to allocate the overlap between the two. And given the unusually good purchase basis, I'd be cautious about calling all of that $1.7 million a market tailwind.

But under this framing, roughly 80% of the appreciation came from higher earnings rather than a lower cap rate.

The market helped, but it wasn't the primary driver of the property's appreciation.

Including cash flow along the way and the exact timing of distributions, the project-level IRR was 347%.

IRR is extremely sensitive to time. It annualizes the return based on when each dollar goes out and comes back.

The 3.4x multiple tells a different story: for every dollar invested, the project returned $3.40.

For perspective, if you invested $1 and received $3.40 exactly five years later with no distributions in between, the compound annual return would be about 28%. In that simple example, the IRR would also be about 28%.

That's why I look beyond IRR...I want to see the multiple, hold period, and cash flow timing.

When you choose a manager partly on their track record, you're betting some part of that track record is repeatable.

So you want to know whether you're paying for operating skill, a great purchase basis, leverage, favorable market timing, or some combination.

When someone shows me an extraordinary historical track record, I ideally want to know four things about each deal:

That's the context I'd want before deciding whether any track record result is repeatable. IRR by itself is incomplete.

In this case, NOI grew 86.5% without a single point of occupancy gain, and most of the appreciation came from higher earnings rather than a lower cap rate. 

But the operator bought unusually well, the market helped, and leverage amplified the result. It also closed in December 2020, when cap rates were compressing broadly.

If you have feedback or there's a topic you'd like me to cover in a future newsletter, reply to this email. I read every response!

All the best,

Ben Kahle

Managing Partner | Wellings Capital