Mitigating Risk in Multifamily Deals

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.

Join our Wall Street Multifamily group on LinkedIn and Facebook for value-add multifamily content and to network with like-minded investors.

How To Approach Multifamily Brokers

I get this question a lot and it’s a valid one. How do you approach brokers if you have never done a deal before? It’s a good question because you run into a chicken or the egg issue: you need to get a deal done to show credibility but you can’t get that first deal without interacting with a broker (you can try to go direct to seller but that’s another topic). 

I think many stay on the side lines until they gather up enough courage to reach out to brokers. That’s totally understandable because you want to come across like you mean business and know what you are talking about. I spent ten years in private equity, interacting with the investment banking community to source deals just like you would with brokers in multifamily. At any given day, I would interact with bankers from multiple industries from software to healthcare services. To be effective, I would have to be well versed in each respective industry to garner the respect from these sell side bankers. This involved getting up to speed with current market events, learning the lingo and industry jargon, and knowing who the movers and shakers were. But ultimately, I would have to act fast, be responsive, and be ready to provide constructive feedback on deals. I never had much time to get up to speed when looking at a new industry  before interacting with bankers. Over time I developed a knack for breaking down industries to their key drivers quickly so I could have a meaningful discussion. 

If you’re new to deal making, the take away here is to not dwell too much in educating yourself because you can be stuck in that phase forever. It’s easy to resort to not having enough education as an excuse for not taking action. A big part of the learning process is to actually learn by doing. Like with anything, it takes practice and you get better the more reps you do. 

Here are some other key pointers when approaching brokers:

• Be specific about what you are looking for – The more defined your criteria the better. It shows that you have thought about your approach and wherewithal to handle those types of deals.

• Explain how you intend to line up your equity and debt – This is critical because brokers won’t have confidence in your ability to close if you can’t convey your ability to raise the capital.

• Describe your team and their roles – This includes the members of the sponsorship team as well as third party service providers (i.e. property management company, etc).

• Be cordial and professional - It sounds obvious but some folks feel they need to be super aggressive when dealing with brokers to come off confident. It’s about building a long term relationship so be respectful.

• Be mindful of the broker’s time – When you set an appointment, show up on time and do some prep work beforehand.

• Close the loop on deals - If a broker shows you a deal, be prepared with comments and questions and provide good feedback. For deals that don’t meet your criteria, make sure to formally pass on the deal and provide your rationale. With more feedback you provide, brokers will have a better idea of the kind of deals to present you next.

• Be persistent – Brokers are inundated with buyers in today’s environment so it’s challenging for them keep track of all the conversations they have. It’s wise to keep on their radar with multiple touches through emails, phone calls, and text. If you’re new to multifamily, brokers will notice your persistence and know you mean business.

What are some other advice for approaching brokers?

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.

Join our Wall Street Multifamily group on LinkedIn and Facebook for value-add multifamily content and to network with like-minded investors.

'Tis the Season for Budgeting

Given that we are in budgeting season, I thought it would be helpful to share some of our experiences having acquired and taken over two properties in the fourth quarter.

I particularly wanted to focus on the transition between your underwriting budget and the operating budget from your property management company (PM). Our internal underwriting process begins with our initial view of the opportunity based on our analysis of the T12 and Rent Roll using our proprietary models, due diligence, and comp analysis. We also draw from intel from properties we know in the immediate area that we either own, invest in, or have pursued.

To substantiate our underwriting, we have our property management company come up with their own budget for the property independently so we can compare them. Ideally, you’d want the property management budget to be more favorable to your underwriting so that you have a buffer to execute and achieve your returns to your investors. One issue that we have seen at this initial budget stage is that prospective PMs know this and will at times produce an aggressive budget so they can win your business. New sponsors entering a new market often fall prey to this, underwrite to an aggressive PM budget, and later are forced to reforecast their budget down after take over when they have a better feel for the property and submarket.

PM budgets are sometimes developed by the business development department with little or no feedback from the staff that end up managing the property. What we underwrite for our investors is typically a hybrid of our estimates and that of the PMs (whichever is more conservative).

Key Budget Process Takeaways

• Engage your property management companies early in your process. We like to have a PM budget in hand before we put in an offer, specially if we’re in best and final.

• Ask who was involved in developing the budget and ensure the folks spending your budget have bought into the numbers.

• Don’t take the PM budget as gospel. Make sure to scrutinize their methodology and assumptions because at the end of the day, you will be held accountable by your investors for meeting that budget.

• Confirm that a true market survey (physically shopping comps) is conducted. Don’t simply rely on local area market reports as they only tell part of the story.

• Understand the feasibility of other income streams as they can add tremendous value or be overexaggerated and cause a large miss in revenues. This typically is uncovered through shopping comps and conducting a tenant survey.

• Analyze how the property is currently being operated and be realistic about the improvements you underwrite. Often times, we see PM budgets showing vast improvement in operations even though the current manager is a highly professional and reputable PM company.

• Income is important but focusing on expenses is what separates the great operators from the good. We see rule of thumbs (i.e. $300/unit for Contract Services) used too loosely for expenses. A deep dive into the specific line items on a T12 is a must as every property is different and may require a different expense profile.

Note that property management companies have their own approach to the budgeting process. Some PMs provide a preliminary budget during underwriting but will refine the budget after take over once things have settled. The issue with this approach is that the budget may come down depending on what is uncovered. We prefer to have a monthly detailed budget completed prior to take over so that we can ensure we have the optimal business plan and capex budget to hit the ground running the day after closing. This also ensures the PM is focused on our asset and a smooth takeover.

What are some budget process tips you have picked up in your experience?

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.