Over the past decade, RealtyMogul has served as a market-leading technology platform empowering investors to make their own decisions regarding their real estate investments. During that time, investors have invested over $1 billion on the RealtyMogul Platform, spanning more than 400 distinct equity and debt investments across a wide array of property types. The Platform also provides investors with exceptional ongoing administration services through a fully dedicated team to support the administration of each deal throughout its lifecycle. RealtyMogul would like to share some of the most important lessons learned over the past 10 years that you may find useful as you make prudent investment decisions of your own, including:
- Don’t judge a book by its cover. Sometimes great opportunities can be overlooked
- The age-old saying about “Location, Location, Location” may be true, but it may not be the whole story
- Consider whether the debt strategy is aligned with the business plan
- Consider the stage at which you are entering the deal as an investor
- Not all Sponsors are created equal; A Sponsor’s ability to meet timelines varies dramatically
- Movements in cap rates can be just as impactful as business plan execution
Don’t judge a book by its cover. Sometimes great opportunities can be overlooked
For this takeaway, let’s look at two very different examples of Multifamily opportunities.
The first opportunity is a newly built, Class A, mid-rise building, located in the heart of an established gateway city. The property is being acquired vacant and the business plan is centered on lease-up risk.
The second opportunity is a 1980s vintage, Class B, garden-style project with substantial deferred maintenance. The property is located in a tertiary market, struggles with vacancy and rents are well below-market. The business plan is to correct deferred maintenance, complete interior renovations upon tenant rollover, and re-lease the units at higher rates.
Both opportunities hinge upon correctly executing a Value-add leasing strategy. While the Class A project may appear like the better investment at face value, given its location, age, and quality of construction, the Class B project may actually offer a much better risk/return profile. The Class A project in this example likely has lower risk; however, depending on how much the Sponsor (“Buyer”) paid for the vacant building, the prior owner (“Seller”) may have already extracted much of the value. In other words, the new Buyer may have miscalculated the actual economic upside. While the Class B project likely has a higher level of risk, the new Buyer could potentially exploit inefficiencies that are not accurately reflected in the pricing.
In this example, here are some possible considerations:
- The 1980s vintage and deferred maintenance together make the building appear dilapidated, but the major building systems (roof, mechanical, plumbing) are in great condition, allowing the Sponsor to focus their capital investments on cosmetic upgrades that directly translate to higher lease rates.
- While located in a tertiary market, the property’s submarket is the fastest-growing submarket in the entire region with respect to working professionals, and favorable shifts in demographics appear poised to translate to higher leasing velocity for this specific product type.
- The project was previously not able to retain its tenants due to the prior owner’s poor property management. Oftentimes, smaller “mom-and-pop” operators may fail to unlock a great deal of value in their properties. But once an institutional-quality owner takes over with their own property management team, the rates of leasing velocity and quality of capital improvement projects can greatly improve, which in turn translates to higher lease rates.
For example, we observed a deal in the Mid-Atlantic region where the Sponsor acquired an asset from a prior owner who had been employing a relatively inexperienced property management team that was unable to generate a meaningful ROI on renovated units. After the acquisition of the property, the new Sponsor noticed that the tenant pool was comprised mainly of two groups – working-class professionals and high-earning technology professionals, with a recent influx of the latter group. Based on this information, the Sponsor created a two-tiered renovation plan which called for renovating approximately 75% of the units with a “standard” upgrade and the remaining 25% with a “premium” upgrade. The standard upgrades were in high demand given the lower associated rents, and the cost savings allowed the Sponsor to invest in best-in-class upgrades for the premium units, which in turn commanded market-leading rental rates. Ultimately, the weighted average ROI across all units was greater than 25%, higher than what had been originally underwritten.
The age-old saying about “Location, Location, Location” may be true, but it may not be the whole story
When looking at two seemingly comparable deals that share similar characteristics such as vintage, construction quality, and even a general location like the same MSA (Metropolitan Statistical Area), consider paying close attention to the submarket. Properties that have struggled due to fundamental issues like tenant credit quality, high crime rates in the surrounding area, and limited access to public infrastructure are typically very difficult projects to turn around.
As an example, investors on the RealtyMogul Platform have invested in numerous deals in the Dallas-Forth Worth MSA, which has been viewed as a strong market over the past several years. However, one particular deal was situated in a uniquely challenging submarket. Credit quality was a major issue at the property, unlike other assets in the MSA. For instance, a handful of delinquent tenants completed midnight move-outs, and the Sponsor was unable to collect the unpaid rent. Additionally, one tenant at the property was even running an illicit business out of the property. When these facts were uncovered, it impaired leasing velocity at the property. Compared to the other deals in Dallas-Fort Worth MSA, the property generated very different returns.
Experienced local Sponsors may mitigate such concerns presented by a challenging submarket, particularly if they have asymmetric information. For example, a Sponsor may know exactly what types of improvements are needed to attract the right tenant profile. Although crime rates may be slightly elevated, the school district is actually one of the best and most sought-after districts in the submarket. Families in this market expect laundry in-unit and one Sponsor may know this is critical to attracting families to their project, while another Sponsor may not.
Additionally, an experienced local Sponsor is more likely to be mindful of exogenous risks to the project such as the likelihood of a local municipality to modify existing regulations. For example, a recent ballot initiative passed in Los Angeles requires an additional tax on the sale of any Multifamily asset greater than $5 million. An out-of-town operator may not be familiar with this change in taxation, but it is highly likely that an experienced local operator would know about the initiative from the news and existing brokerage relationship. As soon as the ballot initiative passed in November, one particular Sponsor on the RealtyMogul Platform immediately started engaging with brokers to market the sale of the property in order to close on a sale before the new tax takes effect.
Consider whether the debt strategy is aligned with the business plan
It is very difficult for anyone to consistently and accurately predict future movements in the debt market. Rather than simply acquiring the best debt, it is critical for Sponsors to identify the best debt for the project. Over the past handful of years, RealtyMogul has witnessed multiple Sponsors lock in long-term fixed-rate financing for quick value-add programs. However, these Sponsors were often stuck with materially burdensome defeasance costs at refinance/sale in a declining interest rate environment.
For example, in 2017, one particular Sponsor locked in a 10-year fixed-rate loan with a Life Insurance Company at what appeared to be an attractive rate at the time. However, the estimated hold period for the project was only 3 years. Once the business plan was executed within that period, it was time to sell the asset. However, rates had fallen dramatically over the three years, and the yield maintenance penalty to pay off the loan was nearly $1.5 million. A flexible, floating-rate bridge loan would have likely been a better fit for a project like this.
Conversely, many Sponsors will utilize floating rate debt to execute short-term business plans, and may partially mitigate the risk of a rising interest rate environment by also employing an interest rate hedging solution (e.g., rate caps or swaps). However, if the expiration date of the hedging instrument does not match the maturity date of the underlying loan, the project can suffer from extreme interest rate risk when the hedging instrument expires. The more flexible the debt is (e.g., favorable prepayment schedules, inclusion of extension options, limited restrictions on how specific buckets of reserved cash are utilized), the more likely it is that the debt will ultimately align with the Sponsor’s business plan.
Consider the stage at which you are entering the deal as an investor
Looking at Multifamily as an example, the proforma IRRs for Development deals are often at least 3% higher than those projected for Value-Add deals. It makes sense that as the risk profile for a Development deal is higher than for Value-Add; thus, most would agree that the commensurate required return should be higher as well. The higher the number of variables impacting business plan execution, the greater the risk profile.
Two of the dominant variables that impact Development deal execution are timing and costs. One way Sponsors may mitigate the risk factors of increasing costs or delayed delivery is to enter into construction deals as close to groundbreaking as possible. At this point, the Developer likely has permits in hand or is close to acquiring them. Additionally, the closer the project is to breaking ground, the more likely it is that the Developer has executed contracts (guaranteed maximum price or “GMP”) with the General Contractor or subcontractors and has locked in pricing for materials and labor. Change-orders or permitting delays can still impact the cost and timing of a project after groundbreaking takes place, but the major variables are typically solved by this point.
The same may be true for Value-Add Development. Sometimes, the prior owner will commence a unit-renovation plan to prove out rents. Or, a Sponsor will acquire an asset, execute their business plan for several months, and then market the deal as a recapitalization opportunity. For example, there was a deal that closed in late 2021, but the Sponsor acquired the relevant asset in January of 2021. They had underwritten sizable rent increases for their newly renovated units in their original underwriting. Between January and Q3 of 2021, the Sponsor actually outperformed their own proforma rents by nearly 8%, renovated half the units, and reduced their business plan timeline by eight months. This type of evidence of execution may provide investors with great confidence in the Sponsor. The Sponsor was able to underwrite new equity investments at a lower preferred return because of the Sponsor’s early success and ability to materially de-risk prior to new investment.
Not all Sponsors are created equal; A Sponsor’s ability to meet timelines varies dramatically
Whether it is lease-up schedules, distributions, project permitting, or anything else, Sponsors may have difficulty balancing the right amount of optimism with an appropriate level of conservativism. Over the past handful of years, we’ve seen a variety of exogeneous shocks impact the commercial real estate industry from Covid-19 to geopolitically induced supply chain disruption. Additionally, unforeseen endogenous issues at a project can impact the timing of other action items. For example, a delay in the project permitting can delay the lease-up, which will in turn delay distributions.
For commercial real estate products in particular (e.g. office, retail, industrial), finding the right tenant can take time and require additional requirements. Most Sponsors will try to find the right tenant, rather than the first one to submit an LOI (Letter of Intent). Moreover, to secure the right tenant, a Sponsor may need to install specialized tenant Improvements, demise a vacant space to a smaller configuration, or offer rent concessions. These decisions can impact the timing of cash flows, and therefore the timing of distributions.
While delays in cash flow and/or distributions are usually unwelcomed, the Sponsor may be executing the business plan in a prudent manner that will serve the project well in the long run. For instance, a Sponsor may deliberately force vacancies in an apartment building to speed up the Value-add renovation program.
We have found that not all Sponsors are created equal – while some Sponsors can execute 10-unit renovations in a given month, another Sponsor may only be able to deliver 4 or fewer. While discrepancies in execution may depend on the project itself (e.g., the number of vacant units, the demand for lease-up for newly renovated units, and the location of the property), another variable may be the Sponsor competence – does the Sponsor have their contractors lined up and ready to go the day of take-over, have the sourced the proper materials, do they use a consistent design for all unit renovations, how do they drive execution, etc.?
Movements in cap rates can be just as impactful as business plan execution
This takeaway is best illustrated by means of an example using two scenarios. In both scenarios the Sponsor acquired a property with an NOI (Net Operating Income) of $1 million at a 6.00% Cap Rate. $1 million / 6.00% = $16.67 million.
In the first scenario, Sponsor #1 has incredible tactical business acumen and is able to complete the lease-up in record time and increase lease rates by 20%. The NOI for the property is now $1.2 million. If cap rates (which are primarily driven by market forces), don’t move--staying at 6.00%-- the property is now valued at $20 million. $1.2 million / 6.00% = $20.0 million.
In the second scenario, Sponsor #2 is an incompetent operator, unable to increase lease rates by a penny, and the NOI remains at $1 million. However, the economy is red-hot, investors require a lower return for commercial real estate investments, and cap rates fall or “compress” by 100 basis points. The cap rate is now 5.00%. $1 million / 5.00% = $20.0 million.
In both scenarios, the property’s value has increased from $16.67 million to $20.0 million. However, in the first scenario, the Sponsor created value through executing its business plan and increasing lease rates at the property. In the second scenario, the market is effectively the entity that created the value by discounting the future cash flows at a lower rate.
Assessing going-in capitalization rates at the acquisition and projected exit capitalization rates is one of the most important considerations when underwriting a real estate project. While no one has a crystal ball, careful consideration of comparable sales and forward projections is paramount.
Our goal at RealtyMogul is to empower investors to build the real estate portfolio that meets their personal investment goals. We provide detailed, transparent deal level information, access to Sponsor webinars, Sponsor FAQs and more. We hope that by sharing the experiences insights we’ve observed over the past decade, that you will be further equipped to evaluate real estate investment opportunities. Please visit RealtyMogul to see current investment opportunities.
This article is for informational purposes only, and is not a recommendation or offer to buy or sell securities. This content is intended for accredited investors only. Information herein may include forward looking statements and is for informational purposes only. Forward-looking statements, hypothetical information, or calculations, financial estimates and targeted returns are inherently uncertain. Past performance is never indicative of future performance. None of the opinions expressed are the opinions of RealtyMogul. Advice from a securities professional is strongly advised, and we recommend that you consult with a financial advisor, attorney, accountant, and any other professional that can help you to understand and assess the risks and tax consequences associated with any real estate investment.