Continued from previous post....Assume that in the first year we were only able to distribute $50k to investors as detailed in the previous post, and that over the next four years we are able to improve that distribution to $75k in yr2, $125k in yr3 and yr4, and $150k in yr5, and that we used all of our reserves for replacement to keep the hotel and its contents fresh, functional, and competetive, without having to inject any additional capital from our own pockets. We decide that we will sell the hotel at the end of yr5. What amount might we realistically project as an achievable sales price for this hotel 5 years down the road? Most of the time a proforma will assign a cap rate to the latest yearly EBITDA amount to determine what a reasonable terminal value (i.e sale price) might be. For this hotel the yr5 EBITDA projection is going to be $850k...so an improvement of $100k/yr from the current $750k/yr level. Hotels, 5 years from now, may be trading at an 8% cap rate (but maybe more, maybe less...who knows). So $850k/8% = $10,625,000 terminal value. At that time the principal balance still remaining on the $7M mortgage will be $6,655,000 which will be paid off at closing. That leaves $3,970,000 to pay for closing costs, sales commissions, etc - figure about $350k. So the investment group will keep the remaining $3,620,000. So the final cash flow for the investors will be a $3M investment when we purchase the hotel, a $50k return at the end of yr1 from operations, $75k return at the end of yr2, $125k for yr3, $125k for yr4, $150k from operations for yr5, and the $3,620,000 from the sale of the property. If you calculate the IRR for this cash flow (easy to do on a spreadsheet with the IRR function) you will get a 7% IRR (internal rate of return) for your invested capital. The investors will realize a net positive cash flow of $1,145,000 over the projected 5 yr investment lifespan. The question you need to answer next is do you really believe your assumptions will hold true over the lifespan of the investment, and if you are willing to bet they will hold true (or maybe even improve) for a projected 7% internal rate of return over the 5 years on your invested $3M. That's really what you need to determine if an investment is worth the risk....not just a one year cash on cash analysis. The alternative would be to invest the $3M in a "safer" asset. T-bills are usually a safe bet, but you won't get a 7% annual return on them. So what do you do? How do you invest your $3M? The stock market? Mutual Funds? Bernie Madoff? Its always going to be a crap shoot. Your trying to predict what will happen in the future, and although we can formulate "educated" projections, they are still always just going to be "best guesses". I like to say numbers don't lie, but you can make them say just about anything you want them to say. Adjusting (manipulating) your assumptions (guesses) can yield all kinds of wonderful projected returns. The question is will you (and your investors) drink the kool aid your serving up? If anyone reading this has any critique of my analysis please post it...Always interested in new ways of looking at a potential investment.
Jul 9, 2009