First, let’s define some key terms:

Limited Partner (LP): passive investor with limited control rights

General Partner (GP): active partnership with control rights who organize and offer the investment.

Promote: Share of profits allocated to the GP, usually after a preferred return is paid to LPs

Preferred Return: the return that LPs are entitled to before GPs can earn their promote

Cash on Cash Return: Return metric that measure return on capital (Cash Flow / Capital Invested)

IRR: Internal rate of return, a sophisticated return metric that provides the time value of money-adjusted return of an entire project (capital outlay, cash flow, and liquidity events) – must include return of capital.

Waterfall: type of profit-sharing model that includes tiers or hurdles in order to incentivize GP performance.

Hurdle: the return threshold that LP cash flows must achieve to advance to the next tier in an equity waterfall structure.

You can see that both structures feature a preferred return, but it is important to understand that they can have completely different implications on LP returns due to the hurdle type. Let’s start with the more simple structure: cash on cash hurdle + Promote. In this example, LPs are entitled to an 8% cash-on-cash (CoC) return before any profit splits take place. In other words, GPs do not get compensated (by earning their promote) until LPs earn 8% on their capital. After this hurdle is met, GPs are entitled to their promote, which is 30% in this example.

In the IRR Hurdle Waterfall structure, LPs are entitled to a certain IRR before GPs can earn their promote. In this example, the IRR hurdle implies that LPs are entitled to a 7% IRR. Note: the IRR hurdle entitles LPs to not only a time value of money-adjusted 7% return ON their capital but a full return OF capital before any profit splits take place. Further, in this example, there is a waterfall aspect present. Here are the implications of the waterfall terms pictured in the above screenshot in simple terms:

Tier 1: LPs are entitled to a 7% IRR preferred return.

Tier 2: Thereafter, profits are split 80% to the LP and 20% to the GP until LPs earn a 15% IRR.

Tier 3: Thereafter, profits are split 60% to the LP and 40% to the GP.

I hope this helped demystify the profit-sharing models most common in commercial real estate syndication.

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The post Understanding Equity Structure: Common Profit-Splits first appeared on Horizonten Properties.

Pitfall 1: Inaccurate Income Projections

One of the first pitfalls to avoid is overestimating rental income. Inaccurate income projections can have a significant impact on cash flow and overall profitability. To address this, conduct thorough market research, analyze historical data, and consider factors such as potential vacancies and economic changes. This approach will help you create more accurate income projections and make informed decisions.

Pitfall 2: Underestimating Expenses

Underestimating expenses can erode profitability and lead to financial challenges. It is crucial to carefully assess various expense categories, including maintenance, property management, utilities, etc. By accurately estimating costs through industry benchmarks, expert opinions, and comprehensive budgeting, you can ensure that expenses are adequately accounted for.

Note: It is very important to understand that pitfalls 1 and 2 deal directly with a property’s NOI projection, which translates to exit valuation – one of the most sensitive factors when calculating project-level returns. This means any slight miscalculation here will lead to an outsized impact on project-level return calculations, potentially leading to heavily misrepresented deals and ultimately unhappy investors.

Pitfall 3: Poor Due Diligence

Thorough due diligence is key to uncovering potential risks and hidden issues. Neglecting this step can have severe consequences. It is essential to inspect the physical condition of the property, review all relevant documentation, and assess market demand and competition. By conducting comprehensive due diligence, you will minimize surprises and make informed investment decisions.

Pitfall 4: Inadequate Risk Assessment

Inadequate risk assessment is a pitfall that can significantly impact multifamily underwriting. To mitigate risks effectively, analyze market trends, tenant demographics, economic indicators, and other factors that influence risk levels. By adopting a comprehensive risk assessment approach, you can make informed decisions and better protect your investment.

Pitfall 5: Neglecting Regulatory and Legal Considerations

Disregarding regulatory compliance and legal requirements is a pitfall that can lead to complications and legal consequences. It is crucial to understand and adhere to zoning regulations, obtain necessary permits, address environmental issues, and comply with tenant laws. By giving due consideration to regulatory and legal factors, you can avoid unnecessary setbacks.

How to Avoid Pitfalls: To navigate these common underwriting pitfalls successfully, here are some best practices:

• Conduct thorough financial analysis, including income and expense evaluations.
• Leverage industry tools, databases, and technology to enhance accuracy and efficiency.
• Seek expert advice from professionals such as appraisers, inspectors, and attorneys.
• Stay current on market trends, industry developments, and regulatory changes through continuous self-education and networking.

Avoiding common underwriting pitfalls is vital for achieving success and profitability in multifamily investments. By understanding and addressing the pitfalls of inaccurate income projections, underestimating expenses, poor due diligence, inadequate risk assessment, and neglecting regulatory considerations, you can make more informed decisions and protect your investments. Remember, diligence, research, and staying informed are key to mastering multifamily underwriting.

I invite you to share your experiences or ask questions in the comment section, as we can all learn from each other’s insights and build a vibrant community of knowledgeable multifamily investors and underwriters.

The post Mastering Multifamily Underwriting: Avoiding Common Pitfalls first appeared on Horizonten Properties.

I argue that cap rate as a return metric fails to tell us the entire story. In fact, it tells us very little about the asset and its potential. This becomes more and more true the further the asset is from a stabilized state (e.g., the heavier the value-add). Take a 100-unit property with current average rents at $1000/mo. running at a 50% expense ratio (operating expenses equal 50% of income). This property generates $600,000 in net operating income ([$1,000 x 100 x 12] x 0.5). If the asking price for this property were $12,000,000, the cap going-in cap rate would be 5% ($600,000 ÷ $12,000,000). If the going market cap rate for assets like this one is 6%, then this asset seems way overpriced on the surface. But what if you learn that the property is experiencing a very high loss to lease (LTL), meaning their leases are severely under market rates? Similar units in the area are renting for $1,300/mo. and the subject property will only require about $1,000/unit in capital expenditures to compete with comparable properties. In addition, we also learn that the property has been run very inefficiently, and new ownership will have no problem running this particular asset at a 40% expense ratio. This is where the cap rate leaves us high and dry, and yield on cost comes in to give us a way to evaluate and fairly compare this value-add opportunity to others. 

The yield on cost (YOC) is calculated by dividing stabilized NOI by total project costs (stabilized NOI ÷ total project cost). Here, the denominator will include purchase price, capital expenditures, sponsor fees, and acquisition/financing costs. Assuming $500,000 for closing costs, this investment’s YOC would be 7.4%. This number is much more helpful when comparing two investment opportunities as it tells a much fuller story than the cap rate. This is because it includes the stabilized performance of the property and the costs associated with executing the business plan. In contrast, the cap rate considers the current NOI and purchase price alone. 

Taking it a step further, we can calculate something called a development spread. A development spread is the difference between the YOC and the market cap rate. It quantifies the value the business plan will add to the asset in the current market context. In our example above, the opportunity provides a 1.4% development spread (7.4% – 6%). Further, dividing the development spread by the market cap rate gives us the development lift, which indicates the value added as a percentage of the market cap rate. The example above shows a 23.3% development lift (1.4% ÷ 6%). This metric is helpful when comparing two opportunities in different markets or across asset classes (or any situation where market cap rates vary between assets).

While the cap rate certainly has its utility, I hope you can see that YOC and development lift tell a much more valuable story when evaluating and comparing two or more value-add opportunities.

Thank you for taking the time to read this article, and consider sharing if you found value! Always feel free to reach out with questions or comments!

Dream bigger,

Jaden George

The post Yield on Cost vs. Cap Rate When Evaluating Value-Add Commercial Real Estate first appeared on Horizonten Properties.

The post Four Key Factors in Conservative Multifamily Underwriting first appeared on Horizonten Properties.

Real estate, specifically multifamily real estate, is an asset class that offers many different strategies to generate above-average returns. Here I will focus specifically on the value-add strategy applied to multifamily. This is the commercial counterpart to flipping or the BRRRR strategy found within the single-family space. Simply put, this strategy includes acquiring a property with a significant opportunity to increase its valuation to then be able to extract it either through a refinance or sale. Before we can delve any deeper, we must understand how multifamily properties are valued.

I. Valuation of Commercial Multifamily Real Estate

Unlike residential real estate (<5 units), commercial multifamily property values are not tied to comparables (comps) in the area. Instead, the value is directly tied to how much income the property produces. In fact, the value of a property can generally be calculated using the following formula:

         Net Operating Income ÷ Capitalization Rate = Property Valuation

Let’s break this down piece by piece:

Net Operating Income (NOI) is the gross property income, from rent and other sources, minus the property’s operating expenses. Operating expenses may include landscaping, waste, water, property management, insurance, repairs/maintenance, and more. Note that operating expenses do not include debt service as this is different for every operator and is a financing expense.

The Capitalization Rate (cap rate) is a reflection of what investors are willing to pay for the NOI that the property generates in that specific market. In other words, the cap rate is essentially a gauge of how desirable a certain asset class is in the market in which it is located.

Example:

Assume recent sales showed that stabilized class A properties in the Denver, CO market were selling for cap rates around 4%. This would mean that you could comfortably value a class A multifamily property that produced an NOI of $200,000 at about $5,000,000 ($200,000 ÷ .04 = $5,000,000).

Cap rates vary across markets and asset classes, among other things.

Example:

It wouldn’t be unlikely for class C properties also in the Denver, CO market to be trading at around a 5% cap rate. This is because higher perceived risk is reflected in higher cap rates, which drive the value of a property down. In this scenario, a class C property in Denver that was generating the same $200,000 in NOI would only be worth around $4,000,000 ($200,000 ÷ .05 = $4,000,000), this makes sense as Class C properties are generally perceived as riskier than class A properties. 

 

II. Adding Value

As a reminder:

         Net Operating Income ÷ Capitalization Rate = Property Valuation

It is important to understand that the cap rate is ultimately determined by the market and there is little we as operators can do to change it in any meaningful way. Therefore, if we want to increase the valuation of a multifamily property, we must focus on the NOI. If NOI equals Income – Operating Expenses, the NOI can be increased by increasing income and/or decreasing expenses.

A. Increasing Income

When identifying value-add opportunities, you will want to look at what the market shows tenants are willing to pay for. Examples include any of the following:

–          Amenities

–          Rebranding

–          Better property management

–          Upgrades (interior and exterior)

–          Security

When looking at properties that may have been mismanaged in the past, you will likely see some great value-add opportunities in the form of higher-than-average vacancy – which can be fixed through strategies listed above – as well as loss to lease (LTL). LTL occurs when scheduled rents of a property are less than what the market says they should be. This is common among properties without the most efficient property management and even more so among mom-and-pop operators. LTL is one of the best things to look out for as it can usually be a quick and non-capital-intensive value-add opportunity with huge upside-translating to disproportionate returns for investors and operators.

It is also important to look for ways to add streams of revenue. Common examples would be covered parking spaces, storage, and garages. The additional revenue is often well worth the capital needed to implement these.

Example:

Let’s say that Foxland Apartments is a 100-unit complex in Hendersonville, TN. The average rent per unit per month is currently $1,500. As a prospective buyer, you conduct market research and find that the average market rent for comps with similar square footage and bedroom counts is $1,650 and the only difference is these properties have a swimming pool and dog park accessible by the tenants. You also know that similar assets are trading at a 5% cap rate in the area. This means that you could increase the NOI by $150 per unit per month-adding $180,000 to the NOI ($150 x 100 units x 12 months = $180,000). Dividing this number by the 5% cap rate would equal $3,600,000 in value added to the property. If these amenities cost you $250,000 to add, then you have achieved a 1,440% return on that capital. 

B. Decreasing Expenses

Just as increasing income directly affects NOI, so does decreasing expenses. Finding ways to manage expenses is another activity that is usually not capital-intensive and can add massive value to the back end of a property. When underwriting poorly managed properties, you will likely come across outlandish numbers for some expense categories. These should jump out to you as gold mines. You might find that the operator has been overpaying for landscaping by about 150% because they use their buddy’s landscaping company. Or you might find that the water bill is about 25% more than your similar-sized property across the street because the toilets and plumbing fixtures are outdated and inefficient. Below is a list of common operating expenses for a multifamily property.

–          Payroll

–          Property Insurance

–          Property Taxes

–          Utilities & Trash

–          Property Management

–          General & Admin

–          Marketing

–          Contract Services

–          Repairs & Maintenance

Finding inefficiencies when underwriting expenses should be incredibly exciting as a value-add investor.

Note: When looking for ways to decrease expenses, do NOT do so with insurance. You will want to be properly insured as you likely have investors behind you who are depending on you to perform and provide expected returns. Insurance ensures that something unexpected does not blow up your deal and is essential to the success of any deal.

III. Exit Strategies

After adding significant value to a property, you may find yourself ready to pull that equity out. Whether it be to pay investors back or to redeploy that capital elsewhere. This usually happens in one of two ways:

A. Sale

Many operators will opt to sell an asset directly after the value-add stage to capture all added value to be able to make final distributions to investors on the deal and potentially be able to redeploy the capital into another deal and do it all over again. However, if you are more of a long-term investor and do not necessarily want to completely exit out of a deal, you can refinance.

B. Refinance

Refinancing allows investors to pull most of the added equity out of a deal to pay back investors or redeploy capital, all while still maintaining ownership of the property and benefiting from the likely large cash flow the stabilized asset is providing. A potential drawback would be the limited amount a lender might be willing to refinance, common numbers are 65-70% loan to Value (LTV). However, with the right value-add deal, this could still be more than enough to pay back all investors and still have a sizable amount for all operators involved.

IV. Benefits

As you can see, value-add investing in multifamily assets provides disproportionate returns compared to other avenues of investing inside or out of real estate. This is simply because of the number of ways to increase the valuation of a property immensely with relatively little capital. At a 5% cap rate, every $100 of monthly NOI equals $24,000 of value. This is why this strategy is a highly sought-after avenue for both operators and passive investors. Depending on how the deal is structured, it is not uncommon for passive investors to achieve an internal rate of return (IRR) of over 18%, with an exit in 3-5 years. Where else can you find returns like that? I’ll wait.

V. Risks

As with anything, one must understand the risks involved. It is very important to know exactly what you may be getting into when looking at a potential property. Most, not all, risk can be mitigated with superb underwriting. You will want to understand every aspect of the current income, current expenses, projected income, and projected expenses. You will want to conservatively underwrite terms for debt-structure both current and future-if you plan on refinancing. You will want to be very conservative when projecting future cap rates at the time of exit as this will drastically affect your valuation. You will want to make sure you have a good idea of how much work the property will require and the exact costs associated with said work. It is always better to be conservative when underwriting real estate deals, especially when investor capital is at stake. Luckily, multifamily real estate is a very forgiving asset class. Risk can be mitigated-not eliminated-through thorough education and by having the proper team in place. This is very much a team sport and going at it alone can be a huge mistake. By leveraging experience team members and ensuring proper education and underwriting, you can ensure minimal risk and maximum returns. 

Thank you for reading and be sure to share if you found this valuable!

 

Dream Bigger,

Jaden George

The post Understanding the Value-Add Strategy in Multifamily Real Estate first appeared on Horizonten Properties.

If you have read or heard about The Law of Attraction, then what Peterson is saying may sound a bit familiar. In my mind, Peterson took a different route but ultimately landed at the same place. If you are not familiar with The Law of Attraction, it is essentially the idea that we attract into our lives what we focus on. Taken side by side with what Peterson has said, it is obvious they are getting at the same revelation. What we are focusing on is our aim, and the world reveals itself to us in accordance with what is necessary to achieve that aim. In other words, if we take the time and really define a goal, it may seem as though we are all of a sudden surrounded by tools that we can use to advance ourselves toward achieving that goal. In reality, our surroundings never change. Yet, by defining our aim (both where we are and where we wish to go), the way the world reveals itself to us changes.

It is one thing to understand this aspect of our mind, but what can we do with this information? Perhaps a better question: what is it that we should aim at to get the most out of this? I will continue harping on Jordan Peterson’s brilliance for this one as well. In Beyond Order: 12 More Rules for Life, Peterson’s second rule is as follows: “Imagine Who You Could Be, and Then Aim Single-Mindedly at That”. Here, Peterson makes the argument you should do just that: conceptualize the highest good that you can achieve, and whom you would have to become in order to achieve it. Take this new version of yourself and make it your overarching aim. Define what exactly would have to happen for you to become that person, and what exactly you would be capable of after becoming him or her. Define the steps you might have to take to get there and make a plan. It doesn’t have to be a great plan – in fact, it won’t be. Your first plan will likely be a bad one, so as you move toward your goal, you will have to change and adapt your plan. You will come to find out that it was riddled with flaws but, as Peterson points out, a bad plan is infinitely better than no plan at all. After making this plan, The Law of Attraction will begin to work in your favor. You will begin to attract people, things, and opportunities all leading you toward your aim.

If you have been following BuyingLifeBack.com for a while, then you have seen the phrase, “Dream Bigger.” This is why I use that phrase. It is when we dream bigger and aim higher that we take the first step toward realizing our full potential in this world. And because of The Law of Attraction, only after taking this first step will the abundance of opportunities begin to reveal themselves to us.

Dream bigger,

Jaden George

The post Dream Bigger – The Necessity of Aim first appeared on Horizonten Properties.