A mentor of mine once said “Numbers do not lie….but I can make them say anything I want.”

This has always been a good reminder for me as I approach new investment opportunities presented for my consideration.

The excitement of seeing the glossy and great returns on paper is real.

However, it is important to remember that such returns are never ever guaranteed. Real estate investments, like any other investment, come with risks. The higher the return, the higher the level of risk one is willing to take in exchange for such return. As such, the returns should be considered in the context of risk-adjusted basis.

So how do you know if an investment opportunity presented to you is a good one?

Well, it ultimately depends on your own investment criteria and target returns as well as your comfort level with the operator. However, as you dive into the deal itself, in order to assess viability of the projections and expected returns, it is important to understand what key assumptions the operator is making when creating such projections and the business plan.

In this article, we offer to clarify just that.

Evaluate the market and sub-market.

I like to say that you can do a lot of things to improve the property and impact its performance. However, you cannot lift it and shift it to a different location.

The market is a key driver for many of the assumptions an operator would make as they look into their crystal ball and look to model the future cash flows the property is expected to generate.

Important items to consider when evaluating a market include – population growth, job growth, median household income level and growth, job diversity, and business-friendly regulations.

Important items to consider when evaluating the submarket (neighborhood where the property is located) include – crime rate, median household income, poverty rate, and demand and supply (absorption).

The factors above will directly impact assumptions discussed in more detail below.

 

What are the topline assumptions around projected rent growth rate, vacancy, and other income? Are they supported by rent comps and the historical and recent market trends?

In 2020-2022, many markets experienced strong year over year rent growth (and in certain markets like Tampa or Orlando double digit growth). This is not sustainable in the long run. In fact, in 2023 the pace of rent growth has adjusted in many markets back to historical levels and even shown rent decline. Thus, assuming astronomical rent growth year over year without support of underlying comps and absorption trends is not realistic (though it can sure make the numbers look juicy).

Apart from cap rates (discussed further down below), rent assumptions have the largest impact on the valuation of a property.

 

What are the expenses?

Are they in line with market ($/door, % of effective gross income), the appraisal, or other public data (e.g. Costar)? Have they been adjusted for expected taxes and insurance increases? Is the expense growth rate in line with inflation?

 

What are the planned operating reserves? Are they adequate?

Unexpected events do happen. Despite best efforts, an operator will not be able to forecast with 100% precision anything and everything that will occur. They can think through and mitigate some of the key risks we discussed in another article but will not be able to foresee everything, especially exogenous events.

This is where the operating reserves, known as a rainy day fund, come in – to help during stormy days of cash flow compression or leakage.

We typically like to reserve six months of operating expenses and debt service OR twelve months of operating expenses.

A smaller reserve of four months of operating expenses and debt service may be appropriate, if the investment has cushion in other areas around the profit and loss statement.

Adequate operating reserves will create additional cushion and higher comfort level and also reduce the risk of capital calls.

 

What is the purchase price cap rate? How does it compare to market? And what is the reversion cap rate?

We discussed cap rates and their meaning in detail another article. For the benefit of first time readers ere, we will briefly note that cap rates represent the unlevered return on investment on the property, i.e. income generated by the property divided by the purchase price assuming the property was bought all cash (with no debt).

Cap rates have a multiplier effect on the valuation of an investment. This is why cap rate assumptions are very important and can have a profound impact on the numbers.

There are many drivers impacting cap rates, and market factors are some of those.

While an operator can control operations of the property, they cannot control the market and macroeconomic events.

As such, if one was to be more conservative, it is best to assume cap rates will increase in the future, i.e. all else equal, the property value will decrease. If the market does not deteriorate (i.e. if cap rates remain stable or decrease over time), that is good news. However, if the market turns, it is best to be prepared. As they say – Plan for the worst and hope for the best.

Ideally the analysis will apply the market (vs. purchase price) cap rate as the beginning point and increase that by at least 10 bps/yr until the point of sale (the amount of the cap rate reversion will depend on the market, market conditions, property type and age, asset class, etc.). While cap rates may or may not increase by the time one sells the asset, an operator would want to account upfront for potential adverse fluctuations in the market. If cap rates do not increase, then the operator has built in adequate cushion.

 

What are the finance terms (loan to value, rate, tenor, interest only period, fixed or floating debt, closing costs, prepayment penalties, etc.) and are they consistent with the business plan? How is the interest rate risk managed?

The lender is the largest partner in a deal. Especially in the current environment where lending terms are being tightened, one wants to ensure the underwriting analysis reflects realistic lending terms and builds in adequate cushion.

While one cannot impact interest rates, the operator can hedge the interest rate risk by fixing the rate or buying a derivative (swap, cap, collar, etc.) to manage the risk.

If the property entails a heavy rehab or is under 90% occupied, a typical agency or bank loan may not be an option, which would leave bridge debt (short term debt, usually up to 3 years) as the typical option. In that scenario, it is important to consider the take out in year 3 (Refinance into permanent debt? Extension, if offered by the lender? Sale?) and the operators past experience with this type of project.

 

What is the capex budget and does it have adequate cushion? Is it based on contractor bids or past experience? Is there a contingency built in?

Especially in the current inflationary environment, it is prudent to build in some cost variance cushion (10-20%). Also it is best if the funds for the capex are raised for upfront vs. relying on cash flow from operations to fund the projects.

 

How are the waterfalls structured?

Do the operating agreement, private placement memorandum, and marketing presentation match? Are dividends used as return on capital or return of capital? Are the preferred return

and dividends cumulative (unpaid returns accumulate over time) or compounded (unpaid return is not only cumulative and therefore added to next year’s balance but is also added to the original investment and as such, earns a preferred return on the new higher base vs. the original investment base) or both? Are the returns presented to the passive investor net of sponsor fees?

That is certainly a lot to consider. Nevertheless, these are important questions to ask so you can develop a good understanding of the underlying investment and enter into it with full awareness of the risks, cushion, and mitigating factors.

We hope you found today’s article helpful and feel better equipped to dive into the next investment opportunity with confidence and find yourself now better positioned to evaluate the underlying assumptions behind these great returns you see on the offering memo.

 

Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com

Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.