Lay out the price, the fund's income distributions and the exit NAV with property growth geared through the fund's debt; the discount adds more than its straight-line share, and fund leverage decides how much an exit shock takes back.
Set out the price paid as the outflow, then the fund's income distributions year by year, then the NAV realised at exit, with property growth geared through the fund's debt, and take the IRR of the line. On an illustrative real estate fund interest with a NAV of 40.0, bought at 84 per cent for 33.60, the four-year IRR is 11.37 per cent, against 6.30 per cent at par: the 16.0 per cent discount adds 5.07 points, more than the 4.00 a straight-line reading suggests. A 5 per cent fall in property values at exit takes the IRR to 9.11 per cent.
Worked in full in The Real Estate Secondaries Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The interest and the fund are illustrative: a closed-end core-plus fund, four years from the end of its life, paying out its net income and expected to sell its portfolio at the end. Figures are in millions.
| Input | Value |
|---|---|
| Reported NAV of the interest | 40.0 |
| Price, % of NAV | 84.0% |
| Fund loan to value | 45.0% |
| Look-through gross asset value / debt | 72.73 / 32.73 |
| Distributions, % of opening NAV, net of fund fees | 4.5% |
| Property value growth a year | 1.0% |
| Years to the sale of the portfolio | 4 |
NAV in year t = GAV × (1 + g)t − debt = 72.73 × 1.01t − 32.73
Distribution in year t = 4.5% × NAV at the start of the year
Exit = NAV in year 4 = 42.95, received with the last distribution
IRR = rate at which the price equals the present value of the flows. In Excel, with the price negative in B2 and years 1 to 4 below it: =IRR(B2:B6)
| Year | Opening NAV | Distribution | Exit NAV | Cash flow |
|---|---|---|---|---|
| 0 | −33.60 | |||
| 1 | 40.00 | 1.80 | 1.80 | |
| 2 | 40.73 | 1.83 | 1.83 | |
| 3 | 41.46 | 1.87 | 1.87 | |
| 4 | 42.20 | 1.90 | 42.95 | 44.85 |
| Total | 50.35 back, 1.50x |
Two features of real estate show up in the line. First, the income: 4.5 per cent of NAV is 5.36 per cent of the price paid, so the discount lifts the running yield as well as the exit gain. Second, the leverage: 1.0 per cent a year of property growth on a fund at 45.0 per cent loan to value becomes 1.80 per cent a year of NAV growth, because the debt does not grow with the assets.
The IRR is 11.37 per cent. Bought at par, the same flows give 6.30 per cent, which is roughly the fund's own return: income plus geared growth. The discount therefore adds 5.07 points. The common shortcut, 16.0 per cent spread evenly over four years, says 4.00 points, and undercounts because it ignores the higher yield on the lower price and measures the gain on NAV rather than on the price: the 6.40 recovered at exit is 19.05 per cent of the 33.60 paid.
| Price, % of NAV | Base, 4 years | Values −5% at exit | Exit in 6 years | 6 years and −5% |
|---|---|---|---|---|
| 80% | 12.84% | 10.55% | 10.80% | 9.40% |
| 84% | 11.37% | 9.11% | 9.79% | 8.40% |
| 88% | 9.99% | 7.76% | 8.84% | 7.46% |
| 100% | 6.30% | 4.13% | 6.28% | 4.92% |
A 5 per cent fall in property values at exit is an 8.81 per cent fall in NAV, from 42.95 to 39.17, because of the 45.0 per cent leverage, and it costs more than two points of IRR at every price. A two-year delay costs less in IRR at par but more at a discount, because the up-front gain is spread over a longer hold. The exit fall that removes the entire benefit of the discount, bringing the IRR at 84 per cent down to the 6.30 per cent at par, is 10.80 per cent of property value. The IRR reaches zero only at a fall of 22.13 per cent.
The exit here is the reported NAV, rolled forward. Appraisal-based NAVs move slowly; if the reported value stands above what the portfolio would fetch, the exit should be marked down before the IRR is believed. That adjustment, and the discount that remains after it, are what an 18 per cent discount actually buys works through.
Build the line from the price, the distributions on NAV and the exit NAV with growth geared through the fund's debt. Bought at 84 per cent, the illustrative interest returns 11.37 per cent against 6.30 per cent at par, and a 5 per cent lower exit with a two-year delay brings it to 8.40 per cent. The workbooks that rebuild the value from the asset tape and test the exit yields are in the free companion files for this book; for the IRR mechanics on a single property, see how to calculate IRR in Excel for real estate.
More than the discount divided by the holding period, because the income is also earned on a lower price. A 16.0 per cent discount over four years looks like 4.00 points a year; on an illustrative fund with 4.5 per cent income it adds 5.07 points, from 6.30 per cent at par to 11.37 per cent. Over six years the same discount adds 3.51 points.
It gears every change in property value into NAV. At 45 per cent LTV, 1.0 per cent a year of value growth becomes 1.80 per cent of NAV growth, and a 5 per cent fall in values at exit becomes an 8.81 per cent fall in NAV, cutting the IRR from 11.37 to 9.11 per cent. A 10.80 per cent fall in values removes the entire benefit of the discount.
The value at which the fund will actually sell, not the reported NAV rolled forward. Appraisal-based NAVs lag the market, so test the exit at lower values and later dates. On the illustrative interest bought at 84 per cent, a 5 per cent lower exit and a two-year delay together take the IRR from 11.37 to 8.40 per cent.
This article is one calculation from The Real Estate Secondaries Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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