In today’s ultra competitive multifamily environment where cap rates continue to compress, sponsors are forced to underwrite their deals tighter in order to win deals. Often, these deals are aggressively underwritten to make them pencil which at the end of the day increases the risk for investors.
When underwriting and pricing deals during my days in Private Equity, I would be mindful of the risk and reward balance of each opportunity. A metric called the discount rate was used when calculating the net present value (“NPV” or essentially the intrinsic value) of a deal. The riskier the deal, the higher the discount rate and therefore the lower the NPV. Intuitively, the “reward” side of the equation would need to be higher to offset the higher discount rate for deals to make sense. The goal was to acquire deals at a valuation lower than the intrinsic value.
Focusing on the growth or “reward” side of the equation is clearly necessary. It’s what grabs the attention of investors and allows them to size up the deal. It’s only half of the equation though. I think true alpha is created when you can generate the same returns as the next sponsor but by taking less risk. On Wall Street, we call this risk-adjusted returns. Essentially, a riskier deal will have a lower risk-adjusted return. As sponsors, we can boost our risk-adjusted returns to investors by spending more time mitigating the “risk” side of the equation; particularly in this current environment where aggressive growth assumptions are more difficult to achieve.
Here are some key areas to mitigate risk:
Loan Terms – Make sure your prepayment penalty structure dovetails with your business plan. We are seeing sponsors having a hard time exiting their deals or selling at a discount because of large prepayment penalties (structured as Yield Maintenance or Defeasance). Floating rate loans with an interest rate cap has been attractive because the prepay can be as low as 1% after a 1-2 year lockout which gives you flexibility.
Stress Test Your Underwriting – Understand what your downside is in the deal and plan for it. Not all your growth initiatives and expense cutting measures are going to pan out so run some “what if” scenarios to see what the impact is to returns. On the loan side, conduct a breakeven occupancy analysis to see how badly performance has to deteriorate before you run into issues servicing your loan.
Forward Looking KPIs – If you follow the economy and the stock market, you have heard the term forward looking or leading indicators. Example of leading indicators include the yield curve and the VIX index. Investors use these indicators to try to predict what will happen next. For your properties, have systems and processes in place to track and monitor forward looking KPIs so you can course correct problems quickly.
Prospective Tenant Funnel – Don’t underestimate the lead time required to acquire new tenants. Tracking the different phases of the process (the prospective tenant funnel) and constantly “filling” the funnel is critical to keeping occupancy up. This is what sales professionals do to acquire new clients so should you.
What are some other ways you can mitigate risk in a deal as operators?
About Us
Overland Capital Investments is a real estate investment company that focuses on acquiring multifamily apartment complexes in markets with solid fundamentals. We implement a disciplined and conservative approach to multifamily investing with a focus on capital preservation, cash flow generation and measured capital appreciation. Our mission is to provide passive income to our investors by buying underperforming multifamily apartments, partnering with good people, and impacting the communities we invest in.
To learn more, visit www.overlandcapitalinvestments.com.
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