Syndications - Cash Flow vs. Wealth Creation

[Alan M.]

I've been looking to invest in some real estate syndication deals. I've met with 15+ sponsors, guys who do deep value adds (low if any initial cash flow in the first few years, but higher IRRs upon exit) to more management optimization or repositioning plays (cash flow from Day 1, but a much lower IRR after exit) and everything in between.

I've just assumed that the total risk adjusted IRR is the same whether the deal cash flows early (small repositioning) or is a deep value add with a higher IRR. In other words, if the repositioning has zero risk and an IRR of 15% but that the deep value add has an IRR of 25% but fails 40% of the time (and assuming failure means I just get my capital back), the two investments are equivalent.

Thinking about it more, I think I've been thinking about this all wrong. 

While I understand that the deeper value adds naturally have more risk with them, I feel like the risk from a deeper value add is more that the investment might not cash flow for a while and then might only be a 17% IRR in total (instead of the 25% in the example above) because they can't get to the rents they want or otherwise can't live up to the pro-forma. There's also a risk premium that someone has to put on the deal for something that doesn't cash flow for a while - investors need to be paid for that delayed gratification of having their capital tied up for years with no cash flow coming in.  But, in general, these are better ways to grow wealth than more conservative repositions of assets that already cash-flow.

So, assuming the above is right, if you don't need the capital back for a while and don't need the added cash flow in the short term, are the higher IRRs associated with deeper value adds just simply better risk-adjusted deals for building long-term wealth?  I know it's far fetched to say "eh, I don't need the equity back and I don't need the cash flow for years, I just want the best long-term return", but, if that really is the case, then what am I missing here?

[Brian Burke]

The definition of "deep" is subjective so it's tough to give a single answer to this question.  Sometimes there's no year 1 cash flow because the buyer is using bridge debt--the value add component might not be all that deep in reality.  Take the same property with a low-leverage agency loan and you'll have lower returns but less risk (and yet more cash flow year 1) despite the exact same amount of improvements needed.

I'm not sure that the correct answer is this level of value add is better for you versus that level--instead I think we are talking about either two different investors or two different buckets of capital. In other words, an aggressive investor or one that doesn't need the cash flow can focus more on IRR and equity multiple and less on Cash on Cash return. While a more conservative investor, or one that needs cash flow, would focus more on the CoC component and less on IRR and multiple.

Having said that, there are people who have capital to allocate to risk platforms and other capital to allocate to safer platforms.  In that case, both strategies could have their place for the same investor.