I’ve heard this comment more than a few times.
And I have no idea how many times it went unspoken…
“I think I’m gonna pass on this one. The ten-year hold is too long. And I doubled my money in five years last time. I’m gonna look for another deal like that one.”
Another prospective investor looking for a shorter hold time. Or trying to double their money twice in a decade.
I get it. The IRRs can bedazzle. And a decade-long hold period can throw a wrench in this world of instant gratification. But don’t forget Mr. Buffett’s quippy comment on this topic…
Doubling your capital twice in ten years (an apparent 4x MOIC) is clearly better than tripling your money in one ten-year hold decade.
Right?
Wrong.
I’m writing this post to help you think outside the common knowledge box. It is critical to account for taxes, risk, and friction costs in your analysis. And I think you’ll be quite surprised at how the actual returns shake out.
Our Hypothesis
When comparing two investments where one is projecting a 2x MOIC (Multiple on Invested Capital) in five years and the other projects a 3x MOIC in 10 years, many investors will immediately gravitate toward the former because they believe they can reinvest that 2x into a similar investment to achieve a 4x in 10 years.
But in employing this obvious math, some investors miss several key points that should be included.
(Note that I say “our hypothesis” because our astute Director of Investments, Troy Zsofka, developed this analysis. Thanks, Troy!)
What is missing from this analysis?
At least three elements are missing from the first blush analysis. And surprisingly, we’ll see below that the math may not be what it seems.
- Taxes: When exiting the initial investment after five years, there will be capital gains taxes assessed. This can be mitigated to some extent by the depreciation achieved from the new investment, a so-called Lazy 1031 Exchange. But unless substantial bonus depreciation is available in the Internal Revenue Code at that time, it will only partially mitigate the tax liability (bonus depreciation will be phased out in less than five years unless Congress renews it).
So, the new investment amount will be less than 2x the initial investment due to the tax bill, and the end result in 10 years will therefore be less than 4x. (I’m not doing actual math here since capital gains, depreciation recapture, and accelerated depreciation will vary by project, state, and year.)
- Risk: Experienced investors aren’t just seeking good returns. They’re looking for good risk-adjusted returns.
An investment that achieves a 2x in five years will, almost certainly, be development, opportunistic, or value-add. There is Execution Risk associated with these types of investments. (Nothing wrong with that, but it must be accounted for!)
By the time the five-year mark is reached, the asset will be restabilized at a value that achieves that 2x return, it will likely have long-term fixed rate debt, and the investment will be significantly de-risked.
If that asset is then sold and the proceeds reinvested into a new investment with a 2x in five years return profile, the entire original investment amount, plus the gains net of tax liability, will be subject to an entirely new set of Execution Risk.
Choosing the investment plan of making two investments over 10 years effectively doubles the Execution Risk to which the original investment is exposed.
- Friction: It is easy to invest in a syndication or fund. You can do it the same day you hear about it.
But it’s hard to perform appropriate due diligence on an operator, their track record, their team, their debt, their underwriting, and a hundred other things that should be studied and inquired about.
Doing this once per decade is hard enough. And most investors don’t have the time, team, or tools to do this on a variety of investments in their portfolio.
Doing this twice as often (every five years) doubles the effort, time, travel, and expense. One might be tempted to rush. Or just wing it. I am all for praying, but that is not a sound investment strategy for most people.
The friction costs here include potential time away from work, family, retirement, and more. And rushing here could add to your risk (see item #2 above).
Furthermore, we should account for the potential time lag issue in making the second investment. Especially when performing careful due diligence. The “slack time” between investments could lower ultimate returns in either scenario, and this could impact the outcome.
A peek at the math
Is the former investment plan of 2x in five years really more lucrative than a 3x in 10? To answer this question, let’s compare them side by side.
We’ll keep as much constant as possible by assuming that it is the exact same investment strategy on the exact same asset. But one aims to sell in year five while the other aims to refinance in year five to access half of the forced equity achieved through the execution and then hold for another five years to achieve that 3x total MOIC over a 10-year hold.
We’ll demonstrate with a $100K investment amount and, for simplicity, assume there is no cash flow along the way in either case, other than from capital events (sale or refinance). (Cash flow would just muddy the analysis without adding any benefit to the outcome.)
Year 5: The first investment is de-risked and has achieved an asset value that translates to a 2x MOIC.
- Investment Strategy #1: Asset #1 is sold, creates a tax liability, and the remainder ($200K minus the tax liability) is reinvested in a similar deal (Asset #2) with a new set of risks.
- Investment Strategy #2: Asset #1 is refinanced, returns the initial $100K to the investor, and continues on as a relatively de-risked investment. The $100K Return of Capital is reinvested, tax-free, into the same investment (Asset #2) that Investment Strategy #1 is.
Year 10: The original investment and the new investment (into which both Investment Strategies #1 and #2 reinvested their respective amounts in Year five) are sold.
- Investment Strategy #1: Achieves less than a 4x MOIC due to the tax liability taking a piece of the sale proceeds that were then reinvested into Asset #2. Capital gains are taxed.
- Investment Strategy #2: Achieves a 4x MOIC ($200K from Asset #1 which is the 3x MOIC minus the $100K already returned, plus $200K from Asset #2 which is the 2x MOIC in five years). Capital gains are taxed.
So, perhaps surprisingly, not only does Investment Strategy #2 achieve the same 4x MOIC over 10 years, but it outperforms Investment Strategy #1 by the degree to which the tax liability in year five reduced the amount that Investment Strategy #1 reinvested into Asset #2. And half of the capital gains are delayed in Strategy #2, providing a more tax-efficient scenario.
But what if the investment in Asset #2 fails?
Assume the new investment in Asset #2 fails and loses all investor capital. It will affect them equally since they both invest in Asset #2, right?
Wrong.
- Investment Strategy #1: The initial $100K turns into $0, a total loss. Uncle Sam is the only winner because some of that loss was paid in taxes after the sale in year five.
- Investment Strategy #2: The initial $100K turns into $200K. Only the gain achieved during the first five years of the initial investment, that which was returned at refinance, is lost. Not fantastic to get a 2.0 MOIC over 10 years, but much better than a total loss. This is because Investment Strategy #2 was only partially exposed to the second round of risk from the new investment.
The bottom line
The takeaway is that, regardless of what the IRRs might look like on paper for Investment Strategy #1 and Strategy #2, the total return achieved by Investment Strategy #2 is both nominally superior and exposed to less risk.
Investing into shorter-term, higher IRR investments, one after another, exposes an investor’s initial investment capital to repeat risks with each new investment and is like playing a game of musical chairs.
When the music stops, will your capital have a chair… or be left exposed?
Another analogy is that each round of risks is like a professional athlete sustaining a sub-concussive impact. How many of those can that athlete sustain before the big one comes along that takes them out of the game for good?
Are you looking to learn more about longer hold times for investments?
On June 12th, be on the lookout for a webinar from Wellings Capital’s fund manager and real estate author, Paul Moore. He will be presenting “A Surprising Case Study on 5-Year vs. 10-Year Hold Times” as part of the LFI Lunch & Learn series. This thought-provoking webinar will challenge conventional wisdom by exploring factors that could make longer hold periods more lucrative than shorter ones for real estate investments. Paul will delve into the underappreciated power of illiquidity and draw from a hedge fund manager’s perspective on why “boring” real estate can outperform sophisticated strategies.
Learn more about the webinar here.
