Green Bison Capital looks for various characteristics during our due diligence of multifamily real estate syndications. We focus in this blog post on topics involved in the due diligence/underwriting of financial models. The five topics listed below do not include the critical topic of what to look for in a geographic market (and a submarket within a particular market) for real estate investing. We will cover the topic of market analysis of a metropolitan statistical area (MSA) in a future blog post.
1) Review of the Sponsorship Team
Green Bison is asking the following questions about the sponsors: Is the team experienced/established? What is their track record? How much of their personal funds are being invested? Have any of their deals run “full cycle”, meaning from acquisition through to execution of the business plan and sale? Do they have an established relationship with the property management firm? Have they had capital calls on prior deals? These questions represent only some of the key questions that need to be answered during the vetting process.
2) Having Adequate Capital
We write this topic from the equity perspective. We cover debt financing later. Adequate budget for Capital Expenditures (CapEx) is clearly needed for value-add deals. Adequate cash reserves are also required for ongoing operational expenses (repairs and maintenance). These reserves should be included as operational expenses and factored into the net operating income calculation.
3) Having Conservative Growth Assumptions
The assumptions for growth in the pro forma financial models should not be seen through rose-colored glasses. Typically, these types of optimistic assumptions are found in the broker’s Pro forma provided in the Offering Memorandum (OM). The assumptions found in the sponsor team’s underwriting should be conservative and should generally be less than what the broker has assumed. Any growth in the market should really just be the icing on the cake. The intrinsic value in the deals should come from the ability to raise rents to get to the proven-market rents and/or reduce the operating expenses by operating the asset more efficiently.
4) “Stress Testing” the financials
Green Bison wants the answers to the following questions: at what economic occupancy is the property at “break even”? How does this “break even” occupancy compare to the historical occupancy values? What was the occupancy during the last recession? How is the net operating income (NOI) affected by these various occupancy assumptions? If the business plan involves renovating a certain percentage of units followed by rent increases, illustrate various timeframe scenarios of this business plan and the effect on NOI. Is there a potential for a large capital expenditure during the investment hold period and was this considered in the underwriting? Would this involve taking units out of operation?
It is important to see the effect on return by looking at various scenarios of exiting cap rate (I.e., the capitalization rate when the asset is sold). Green Bison wants to see conservative assumptions on the cap rate at sale (e.g., a cap rate at sale that is 50 basis points higher than the cap rate at purchase). Typically more than half of the investment return is coming at the sale of the asset (for value-add business plans).
5) Having a Good Leverage Strategy
The use of leverage (debt financing) is a key component to helping manage interest rate risk while also aiding with the return on investment. Debt in real estate, when used prudently, is good debt that provides most of the capital. With debt financing, every dollar of equity capital raised can become 4 to 5 dollars of asset value purchased.
Large multifamily assets can check off the boxes required to get fixed rate financing (provided they are stabilized – about 90% occupancy for the past 90 days). This financing is also non-recourse. The lender considers the asset able to stand on its own and doesn’t need personal guarantees from the sponsor team (other than customary recourse “carve outs” for fraudulent behavior).
The business plan may also be to allow for a floating interest rate but to control the interest rate risk by paying a premium to lock in a “ceiling” rate. This strategy may be less expensive than the fixed rate financing strategy because the fixed rate financing can come with stringent prepayment fees. The financing strategy must be tailored to the intended hold period and business plan of the sponsor team.
