Updated: Jun 5, 2018
As a passive investor, you receive deal packages and executive summaries from syndicators, and most of the time they all look great. As a former lawyer, I can tell you that the written word, in this case, should be taken with a lot of caution. In Israel, where I am from, there is a phrase lawyers use frequently, “the paper will suffer anything” which means there are no limits to what you can write on a piece of paper. It will carry it.
Most syndicators are honest. The vast majority will not try to present false information in their investment package. However, as a passive investor, you should be aware of several components in every deal that can significantly affect the returns the syndicator predicts. In this article, I will discuss the 5 most critical components that you should pay a close attention to and thoroughly investigate if needed. Knowing where to look is key to making an informed decision and choosing the deals with the highest chance of success.
The Exit Cap
I chose to start with the Exit cap because it seems like a small factor in the syndicator’s underwriting and is often overlooked by many passive investors. However, it’s one of the most important factors in any underwriting that can significantly affect returns and can be the difference between a failing investment and a successful one.
The Cap or Cap Rate is the ratio between the Net Operating income (NOI) and the purchase price. The lower the cap rate – the more you pay for a property, relative to its NOI, and vice versa. Sellers always aim to sell their properties at the lowest cap rate, and the buyers’ interest is to buy properties with the best cap rates.
The Exit Cap is the cap rate that the syndicator assumes they will be able to sell the property for by the end of the holding period (at time of exit). If you only change the Exit Cap by, say, half a percent, that can increase the IRR and CoC significantly. Yet the Exit Cap is the most speculative part of the underwriting – none of us have a crystal ball and nobody knows how the market will behave in 3-5 years from now, when it’s time to sell, or even a year from now. Hence, two syndicators can look at the same deal and share similar assumptions when it comes to putsches price, rent, expense increases and even premiums (the increase in rents achieved by implementing a value-add plan – rehabbing the property and renovating the units). If they assume different Exit Cap rates, the more conservative syndicator – the one who assumes a higher Exit Cap than the cap rate at purchase – may pass on the deal, since the underwriting will show low returns, while the other syndicator – who assumes a lower cap rate – might end up buying the property, since their calculations will show much higher returns.
Actionable Advice: always ask the syndicator what cap rate they purchased the property at, and what is their assumed Exit Cap. Then try to assess if the gap is reasonable. For example, I usually assume an Exit Cap that is 0.5% to 1% HIGHER than the cap rate at purchase. I am very conservative in nature (something I inherited from my years of practicing law) and assume that in 5-6 years the market will not be as strong as it is today, and property prices will DROP. If the deal still works with conservative assumptions – then it’s a great deal.
Expense to Income Ratio
As a rule of thumb, and it changes based on the market and property size, expenses should be around 50% of the income. Many syndicators find deals where the income-expense ratio is higher (say 65%) and optimize expenses, usually by bringing an experienced property management company to manage the property. As a passive investor, you should look at the NEW income-expense ratio closely and ask yourself: is the ratio reasonable? If the syndicator assumes a 33% ratio, that might not be realistic.
Additionally, examine by how much the syndicator predicts they can narrow that ratio. Does the syndicator assume they can bring that ratio from 70% to 50%? It’s a pretty significant change and could be hard to achieve in some cases.
If a syndicator assumes they can manage the property better than the seller, it's important to understand their experience in managing multifamily properties, and the same goes for the property management company that will manage the building.
Actionable Advice: look at the current income-expense ratio and the one that the syndicator is aiming to achieve (as indicated in the pro forma). If the pro forma ratio is lower than 50% or if the syndicator assumes they can significantly lower expenses, ask the syndicator how they arrived at those numbers.
Many value-add syndicators, like myself, buy multifamily properties that need some work. They will improve the amenities, add new ones, and renovate the units. By improving the overall look and functionality of the building, they’ll be able to increase rental rates as well as making the property more attractive to the next buyer.
Passive investors who examine a new opportunity should inquire about the renovation plan and understand the specifics, instead of simply evaluating a high-level plan. A good passive investor will ask:
- Can local demographic pay for the renovated units? A syndicator can turn an old unit to a state-of-the-art apartment – but if the building is in a bad neighborhood – not many will be able to pay $200 more for a nicer apartment. Now, the situation might not be that extreme, and yet, even in a decent neighborhood, some syndicators struggle to find tenants who will pay a higher price for a renovated unit. Look at the rent comps if provided by the syndicator or ask them for the information. Understand if there are other nearby buildings with similar vintage (age) and amenities that charge higher rents – this will be a good indication that it’s possible to increase rents.
- How many units does the syndicator plan to complete every year? Does the syndicator assume they can complete a large scope renovation in a short period of time? Renovating a 200-unit apartment building can take 24 months, and sometimes longer. As a passive investor, try to assess if the time frame for a complete renovation is reasonable, and ask the syndicator how they plan to complete it within the anticipated time frame.
- How experienced is the syndicator and the property management in rehabbing properties in this market? An experienced team would know what features are popular among the locals, where to buy high quality materials for the best prices, and whether, as I mentioned earlier, the locals will be willing and able to pay premiums for the upgraded units.
- How high are the premiums? Generally speaking, bumping rents by $400 for a renovated unit might not be easy. Most premiums fall into the $75-$150 range and are considered reasonable. It depends on the specifics of each deal and the market (if rents are under market, for instance, it can be achieved). A passive investor who sees a projected high premium should inquire about the achievability of new rents.
Demand drivers are key in every investment. It’s what draws people to a specific market/area/neighborhood. Look for demand drivers in the syndicator’s materials – is there any reference to job growth? Population growth? Is there a new and promising project nearby – such as a new shopping center, employment center, or even a major road? All these factors will strengthen tenant’s demand for the property. If this aspect is missing in the summary – ask yourself why? Is it because the area is not desirable or strong enough? Is it because the syndicator does not know the area that well? Or it is something else?
Actionable Advice: look for demand drivers and understand them. Always talk with the syndicator about the demand drivers and try to assess how familiar they are with the area. You obviously want someone who knows the location very well.
Refinance and Bridge Loan
Many syndicators project a refinance after 2-3 years, after they improve the NOI. Similarly, if the property is not eligible for an agency loan (if it’s not 90% occupied for the last 90 days), then many syndicators take a bridge loan – which is often, if not always, at a higher rate than an agency loan, hoping to stabilize the property and take an agency loan then.
This strategy can definitely work, but there’s also some risk involved. What happens if the syndicator won’t be able to stabilize the property and get an agency loan? What if in two years interest rates rise even more and a refinance will not be attractive? Or if the syndicator will not be able to improve the NOI? As a passive investor, you need to understand that when a syndicator assumes a refinance event or a bridge loan, it can significantly affect the returns calculation. Without getting too technical, a sensitivity analysis can reveal returns you can expect if a refinance event will not happen, or if it would take longer to stabilize the property and get out of a bridge loan.
Actionable Advice: make sure to ask the syndicator to show you the returns WITHOUT refinancing or with a longer period of a bridge loan. This way you can make sure that your money is more likely to be safe, even if the financing plan doesn’t go as planned.
Conservative in nature, I always make sure that the deal works even without refinancing. Lawyers are used to considering the worst-case scenario in every business situation. We are trained to see the world this way, and that’s how I look at deals. I pass on most of them because they are simply not strong enough to weather the worst-case scenarios. As a passive investor, you must know how to read executive summaries and what to focus on. You will most likely not be as knowledgeable as the syndicator who is leading the deal, but you can nevertheless look in the right places for the most crucial information and ask the right questions.
About the author
Ellie is the founder of Blue Lake Capital LLC, a real estate company specializes is multifamily investing throughout the United States. She is also the host of a weekly podcast called "That REllie Happened?! Unbelievable Real Estate Stories with Ellie". She started her career as a commercial real estate lawyer, leading real estate transactions for Israel’s largest development company. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100,000,000. Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations. She graduated from the MBA program at MIT Sloan School of Management and holds Masters in Law from Bar-Ilan University in Israel.