Leveraged Breakdowns

Live Case Study #1, Part Four: Mental Math Screening Tricks

Introduction

This is part four in a series where we underwrite a live investment opportunity exactly as we would in our real estate private equity jobs. Part one introduced our subject: LSI’s $350M 2029 4.0% Senior Notes. Part two showed you where to find live bond pricing data and explained key terms. Part three demonstrated the basic real estate private equity skill of building a quick financial model with the data discovered in part two. At the end of part three, we left off with the highlight that a 3.55% IRR does not make much sense for a real estate private equity opportunistic fund.

Obviously, investors don’t build entire models from scratch just to realize an investment isn’t worthwhile. There is quick mental math we perform before even analyzing an opportunity. This post will show you what we would have done in the real world before committing time and effort to building a quick model.

Guesstimating Bond IRR with Yield to Maturity

If a bond’s purchase price matches its par value, then its coupon rate is the same as its yield to maturity. For bonds, yield to maturity is effectively your IRR. Yield to maturity calculates: if I buy these bonds today, receive all coupon payments, then get all principal back, what is my yield? In this case, yield is just another word for IRR.

So when I first told you these 4.00% bonds were priced at $103.70 (above par), you should immediately realize that the investment return would be below 4.00%. Understanding this simple rule is a basic real estate private equity skill, because it helps you put your pencil down the moment you realize your time is better spent analyzing other investments. But what if you wanted to quickly guesstimate the IRR more specifically than just saying it’s less than 4.00%? Well then, you want to calculate its current yield.

Calculating Current Yield

Current yield is gracefully intuitive. You take the coupon on the bond, in this case 4.00% (or $4 for every $100), and divide it by the market price, in this case $103.70. In our case, that arithmetic results in a current yield of 3.86%. This could be a common interview question, so make sure you commit it to memory. Current yield is a quick calculation that you can further refine with day count conventions (this particular bond is 30/360), but the rough math of dividing coupon over market price will always land you in the proper ballpark. Don’t get caught up on this, but it’s worth noting our model in part three returns 3.55% because we calculate our return using a more nuanced monthly XIRR formula. Don’t worry, you wouldn’t be expected to do a perfect XIRR calculation in your head when interviewing for real estate private equity jobs, just knowing current yield will suffice.

So these LSI notes aren’t an opportunistic investment, what now?

At this point, we have established these bonds don’t make sense for an opportunistic fund. We arrived at this conclusion through two tricks:

  1. The first trick using YTM proved this bond won’t return above a 4.0%. We could really stop after this, understanding a 4.0% bond trading above par (at $103.70) will never give you above 4.0%
  2. The second trick gave us more precision, telling us our return will be closer to 3.85%.

After performing these two quick math tricks, we wouldn’t even need to build the model which shows us these bonds would return a 3.55%. As a real investor, I would stop and put my pencil down after quickly thinking through the first trick.

Next up, determining the maximum price we’d be willing to pay

But right now, I am not an investor. I am your teacher / mentor / friend (?) and I want to show you what a full underwrite might look like. So let’s put on our imagination caps and enter a world where an op fund investor would continue to pursue this opportunity. To that end, next we are going to repurpose our model to understand the maximum price that would justify an opportunistic investment. See you in the next post.

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