Written By David Thompson
The focus of this article is on analyzing an apartment investment from a syndication point of view. Let me frame it a bit. When I talk with investors, I start high level as for many investors it may be the first time they ever thought about investing in a large apartment. The sheer size of a 200 to 300-unit apartment community does not really come into their realm of investment thinking if they have been actively accumulating a few single-family rental properties and may have gone up the curve a bit on a duplex or fourplex. It’s about this time that I see a lot of investors come to a crossroads. The accumulation of small properties and the active management time and effort it takes may begin to come into full realization. The thought of making a couple hundred bucks of cash flow per month sounds exciting at first but after a while it seems that it will take forever and a lot of properties to reach financial freedom to leave that job you may not be energized about anymore if you ever were.
For those of you who are looking at a hybrid approach or a complete way out of active management, there is hope. Enter the real estate syndicate. The syndicate needs your capital to acquire large apartment properties. Rarely is that going to happen with a couple of partners. Syndication is simply the pooling of investor money where you the investor (limited partner) provide capital and the syndicate (general partner) does all the work. Ok, sounds good so far. But if I’m looking at a deal from a sponsor (syndicate) how do I know it’s a good deal you might ask? Additionally, and perhaps most important, how do I know I have a good sponsor that has my best interests at heart? The latter question I have addressed in another blog titled “vetting an apartment deal sponsor, 10 tips from an insider” so you may want to spend a bit of time reviewing it (link below).
Let’s tackle how I look at a good deal since I vet all the deals that I decide to invest in before I share with my investor base. Note that there are a lot of things one could look at and this is not a comprehensive review but will touch on some of the more important things I like to consider. The framework is the Market / Deal and Team of which all need to be attractive:
Market – I’ll cover this more in a future article. At a very high level, I want a deal in a large city (MSA > 250K people); a submarket (a segment of that city) that is seeing job and population growth greater than the national averages, strong increases in rents and has diverse industries. You want to see growing incomes in that submarket that can support greater rents in the 1,3 and 5-mile radius of the property. We don’t buy on hope, we buy on proven data showing the trend is in place and expected to continue for the foreseeable future.
Deal – At a high level, the numbers fit our criteria if I see 8-10% cash on cash return; 16 – 20% IRR over a five-year target hold. These are numbers that attract investors. I like to see a preferred return of 8%. We really want conservative underwriting and assumptions. That is so important I can’t overemphasize that. I can look at the same deal and it can be underwritten three ways (conservative, at market and aggressive). You want a simple business plan that makes sense. I’ll cover in more detail below as this section is the focus of the article.
Team – I encourage you to read the blog link above on vetting a deal sponsor as its goes into depth on what I look for and is important to review / consider in your analysis. At a high level, you want an experienced team with a proven track record.
At the top level, you’ll hear folks say it’s a great looking deal then you should assume that they are talking about the framework of a great market, deal and the team behind it. I’m splitting hairs a bit and isolating the deal (business plan / assumptions and forecasted numbers / returns). A good syndicate will provide the investment summary to the investor which lays out everything for you in an easy, logical flow. It should include:
Offering Summary – most important numbers like investor return projections, cash distributions and timing to investor, purchase price, cap rate, expense ratios, DSCR (Debt Service Coverage Ratio), hold time and equity required should be laid out on p.1. I know a very sophisticated investor who won’t even look beyond p.1 if the syndicate doesn’t share this up front. Note: the actual offering is included in a document called a PPM (Private Placement Memorandum) which you will also receive.
Investment Highlights – key points on why the operator likes the investment. I like to see a powerhouse market/submarket; simple value add opportunities like outdated interiors most common; below market rents after renovation compared to competition; and easy operational improvements that can reduce costs.
Partnership Structure – preferred returns, splits (GP/LP), waterfalls (optional). Preferred returns favor the investor and 8% min is what I see most. Essentially, the investor (limited partner) gets paid first up to 8% of all distributions or capital events (refinancing cash outs / sales) before the GP gets paid. Splits usually vary with the experience of the operators but certainly 70/30 (LP/GP) is most common. Waterfalls are optional but if the split of 70/30 gets me to the targeted return of say 18%, then changes to 50/50 after that I’m fine rewarding the GP for outsized performance if I can continue to participate in the upside.
Business Plan – what is going to be done to add value? It should be simple ideas that renters want and will pay for. Examples might be covered parking or adding 100sf fences to first floor backyards for extra privacy and pets. Imp Note: the lowest risk and highest return strategy in the apartment investment niche is buying properties you can improve through renovations (interior / exterior) and operationally run more efficiently to increase the net operating income. Buying new construction and development properties can be very profitable in early stages of cycles but value add is a much lower risk strategy when done right. An older property that has been fixed up and stabilized is very attractive to renters because rents can be much more competitive than newer properties and is more insulated from downturns as the newer properties must cover the higher costs of labor and materials. We often see $300 differences in Dallas for instance in brand new vs renovated. That makes a difference for renters and especially to investors in downturns.
Financing of the property (debt terms) – you want to see reasonably leveraged properties of say 75% (LTV – Loan to Value) or less would be normal. The DSCR – cash flow to cover the mortgage should be higher than say 1.25. The higher the safer and banks require 1.2 minimum. A DSCR of 1.0 is breakeven, not a good scenario. Loan terms such fixed or variable rate, length, amortization and rate should be clearly spelled out. In a low and rising interest rate environment as we have now, low fixed rate debt of say 10 years is ideal since we are not expecting to stay in the property longer than 7 years. This also could be attractive for a buyer if loan is assumable when we go to sell in say 3-5 years. I also like to see interest only payments for the renovation period of at least 2 years. This way the operator will not have to use valuable cash flow for payment of a higher monthly payment when principle is included.
Exit strategy (refinance, sale or buy and hold) – you want to know the exit plan. That is when you expect to get most or all your equity back and earn profits on the sale. Most value add syndicates will look to at least refinance or add supplemental debt to the property after renovations are complete and they have maximized the value of the property to return some equity back to investors typically end of year 2 for larger say 200-unit apartments. This reduces investor risk and increases returns. Average hold periods I see are 5 years but should be in the 3 – 7-year range. Beyond that, you are really looking at a buy and hold strategy. Distributions from profits should be at least quarterly and can be monthly.
Market – be clear on why market is strong (catalysts for people / jobs moving in; income levels, etc. to achieve the higher rents you are seeking). Purchase price and rental comps for pre- and post-renovation rents should be under market for competitor’s w/n 1 – 3 miles of the property. The purchase price relative to other sales of like age and size of property in the general vicinity should be below averages on a cost per unit and cost per sq. foot basis. I like to see properties located near major freeways / arteries so it’s convenient for people’s jobs, shopping, entertainment and schools. You should be near “good” schools – review rankings to attract the families which support the unit mix and reduces resident turnover. I like to see properties in at least a B area and preferably in an A area. If we can find a value add play say B to a B+ property (in a B+ or A area) or a A- property in an A area that works.
I like pictures of before and after interior renovation plans and the itemized budget for these upgrades should be provided. It’s common to build contingencies especially if labor and material prices increase, you find something you want to do after you purchase the property that adds value, etc. Better to be over budget than under to avoid the risk of not being able to upgrade the property as needed. Total cost per unit for upgrades should be stated. You want to make sure you are not over improving or under improving.
Unit mix – that fits the market (i.e. % of 1×1, 2×2 3x2s). You want a good number of two bedroom / two bath (2×2) for most residential areas as that is geared to a family unit and are typically more stable renters. If you are targeting near colleges, certainly more 1×1 is logical and would make sense. A sweet spot is about 70% 2x2s in an apartment community for residential areas where we like to buy.
Financial analysis – like to see the five-year cash flow projections with line items and assumptions for each line item. This is where you will find if the sponsor is conservative which is what you want. Some examples: If rent growth has been high like 7-10% in the submarket last 1-2 years, you certainly would like to see operator projections of subject property at normal 3% rent growth. If occupancy has been 95%, you like to see maybe 90% year 1 as that is when the property is being renovated and re-positioned so turnover should be a bit higher and forecasted to be under market. You want occupancy projections slightly below market forecast (i.e 93% vs 95%). Review expense line items and see where the operator expects to see reductions and ensure that plan is clear, simple and achievable. Cutting staff or wages may not be ideal but if you own two properties across the street from each other, certainly one highly talented property manager you pay slightly more can cover both properties at a reduced cost per unit to both properties. See, now that sounds logical doesn’t it.
Sensitivity analysis – stress test of occupancy and rent projections; and cap rate to sale price. You want to understand the breakeven point (B/E). I usually see about 75% occupancy as B/E and making some return say 2-3% if rents are 10% less than projections and occupancy falls to say 81%. Note: you can check area history from 3rd party real estate data firms. For instance, during the last great recession in one of the strong submarkets of Dallas where we were buying, the average occupancy fell to 85% at its low point in 2009. Comforting to know that the property would have held up fine if at 81% we were still making 3% on investor money if rents were 10% less than projected. On the exit cap rate, I’d like to see a minimum of 50 basis point increase at exit. Example: Enter at a 5.5 cap rate, the sale price should be reflective of at least a 6-cap rate or higher. The higher the cap rate the lower the sale price and vice versa (NOI / cap rate = FMV). This greatly impacts the return projections for investors. You want to see all the various cap rate exits and what that does to the IRR numbers.
Refinance or Supplemental Loan projections – Although good syndicates will want to under promise and over deliver, they usually will have a backup document for those investors who want to see what is achievable with the very common practice of refinancing or adding a supplemental loan after the apartment is fully renovated and rents are being achieved per projections. This capital event gives investors more money back earlier in the investment hold period versus waiting for a significant portion of their equity being returned at sale. I like to review this to see what the upside is to this action.
Re-branding / Re-positioning – if the property has a bit of a bad history (say the feedback on the website has been bad or there was an unfortunate incident at the property that made news such as a murder), rebranding is a common strategy. A complete new name, signage, website and new management operations team can turn things around quickly. I want to see this if my research indicates a more positive image is needed. Re-positioning with both interior / exterior (eye candy) and competent, attentive and professional staff is what you want. Re-positioning will improve the tenant makeup as higher rents attract more stable residents and deadbeat tenant’s leases terminate. You want to avoid properties where there is little you can do to it cosmetically other than make costly improvements such as roofs, plumbing, foundations that few residents will pay extra for.
PPM – Private Placement Memorandum. This is required for every private placement deal per the SEC. It’s a detailed legal document that lays out the offering to the investor including things like structure of the deal, risks, partnership agreement, investment summary is included again and the subscription agreement. These can easily be over 100 pages in length. You want to review the PPM and ensure you understand the main parts so you are comfortable with the setup. I’ll cover the PPM in more detail in a later article. Suffice to say when reviewing a deal, you want to read the PPM. Bottom-line for now, ask questions if you are unclear on something.
Certainly, this article doesn’t cover all the things a more experienced analyst or investor may want to look at but gives most investors a good overview of some of the common considerations to thing about when reviewing an investment.