Protect & (pre)Serve: Let’s Talk About Our Conservative Investment Philosophy & Process…

Constructing a property proforma is part art and part science. It is science in the sense that there are generally accepted principles upon which it is constructed, but it is art because it is fundamentally just an estimate built upon a series of assumptions.

“The three most important words in investing: Margin of Safety.” - Warren Buffett

“The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” - Benjamin Graham

The “meat” of this post reinforces and dives deeper into one of our most important investment philosophy elements: conservative underwriting.

Prior to making a commercial real estate investment, one of the most important tasks on a real estate investor’s to-do list is to create a financial projection of the property’s cash flows and Net Operating Income (NOI). This process is known as “underwriting” the property and the resulting financial projections are displayed in a document called a “proforma.”

One of the most challenging aspects of underwriting a commercial property investment is that the holding period can range anywhere from 3 – 15 years, or more. Projecting income and expenses over this time period requires the underwriter to make a series of assumptions about future property and economic conditions. Often, the success or failure of the investment depends on the accuracy of these assumptions so it is critically important that they be conservative.

For those of you looking into real estate investments, there are five critical assumptions that should be tested and challenged as part of the conservative underwriting process.

(FYI: Some of this may be a review to you from earlier blog posts!)

Entry & Exit Cap Rate

(see our post on cap rates)

Perhaps more than any other variable, the property’s purchase and sale price are the biggest drivers of investment return metrics.

The entry capitalization rate (“Cap” Rate) is calculated by dividing the property’s year 1 Net Operating Income by the estimated purchase price. This cap rate should be compared to recent sales for similar properties to ensure that it is reasonable. More importantly, the entry cap rate also provides a reference point for the exit cap rate.

The exit cap rate is a choice made by the underwriter to determine the sales price at the end of the investment period. It should be informed by the entry cap rate and adjusted for estimated market conditions at the time of sale. It is critically important that the exit cap rate assumption be conservative because the ultimate sales price has a meaningful impact on the total returns for the investment. As a general rule of thumb, investors should look for a 15 to 20 basis point increase in the cap rate for each year of the investment holding period. So, if a property was purchased with an entry cap rate of 6% and the estimated holding period is 10 years, it would make sense for the exit cap rate to be in the 7.2% – 7.8% range. This increase would account for the uncertainty in future market conditions. However, this “rule of thumb” is not always accurate and depending on certain expectations of a future market, investors may consider expanding this assumption or even contracting this assumption. For example, in the current market it is challenging to anticipate a significant expansion in multifamily cap rates.

Vacancy Rate

(see our post on vacancy rates)

When investing in a multi-tenant property, it is a given that there will be some vacancy during the holding period. To account for this, the underwriting model needs to include a line item for vacancy.

The vacancy assumption is driven by a number of data points including, the property type, tenant quality, number of units, location, supply and demand, and general economic conditions. Physical vacancy, meaning the number of empty units, impacts a property’s gross rental income and its ability to fund its operations so it should be minimized to the extent possible.

In a value-add investment, vacancy may start out high as the property is being repositioned, but it should stabilize over time. As a general of thumb, stabilized vacancy should be estimated at 5% – 10% of gross rental income, but is always highly location specific. Anything significantly different than this should be justified with as much data as possible.

Rent and Expense Growth

(see our post on rent growth + see our post on asset management)

Over a long period of time, inflation typically drives the cost for goods and services higher. A proforma should reflect this.

Aside from inflation, rental growth can be driven by a variety of factors including market supply and demand, seasonality, economic conditions, and property location. To account for these, a proforma should include an income growth assumption. As a general rule of thumb, it should be in the range of 2% – 3% annually. Anything appreciably different needs to be fully supported by market data.

Operating expenses are also driven higher by inflation. As such, an assumption needs to be made about their growth as well. Some expenses, like landscaping and some specific maintenance can run on multi-year contracts so they can be reasonably simple to forecast. Other expenses like property taxes can have significant increases after purchase, which must be considered. Further, other expenses like utilities and property management are variable. Property insurance can fluctuate on an annual basis as well. To account for this variability, a general expense growth assumption must be made. Generally, many proformas will assume between a 2% - 3% annual expense growth rate.

Financing Terms

(see our post on financing)

Using debt to purchase a CRE asset can help to boost returns. However, it can also raise the risk profile of the transaction in certain circumstances because the terms can change over the holding period.

In order to accurately model the cost of the debt, it is necessary to know all of the loan inputs like interest rate, term, amortization, loan-to-value ratio (LTV), and loan amount. These factors will impact the calculation of the required monthly payment, which is one of the most important proforma inputs.

In addition to the loan terms, it is also important to know whether or not there will be any loan covenants that require the property meet certain tests during the term of the loan. For example, it is common for a lender or financial institution to implement a debt-to-service coverage ratio (DSCR) covenant that requires the property’s income to be 1.25X the loan payment at all times. If there is a shortfall, it is a technical default and could mean that the lender calls the loan. Proforma results should be considered in the context of potential loan covenants.

Capital Expenditure (“capex”) Reserves

(see our post on capex)

Things break and the property’s physical condition degrades over time. As a result, things need to be replaced and renovated. The cost associated with these improvements can add up. To account for them, a certain amount of money should be set aside from the property’s operating income each month as reserves to pay for these future expenses. The exact amount varies by property type and size. For example, a common rule of thumb is $250 per unit, per year for a multifamily apartment building.

Failure to account for reserves can cause issues down the line if a major repair becomes necessary and there are no funds available to pay for it. Reserves should be adequately funded to avoid this issue.

Aside from this assumption in our underwriting, we always estimate capital expenditures ahead of making any investment, which generally are not expenses that impact NOI, rather improvements that are capitalized over the life of the investment.

Tying it Together

Constructing a property proforma is part art and part science. It is science in the sense that there are generally accepted principles upon which it is constructed, but it is art because it is fundamentally just an estimate built upon a series of assumptions. Every deal is completely unique.

To ensure the assumptions are as accurate as possible, and investments are as successful as possible for the long term, they should be conservative, based on market data, and within the generally accepted bounds of proforma construction. We, at CF Capital, remain committed to underwriting opportunities conservatively and making investment decisions with risk mitigation in mind.

————————————————————————————————————————————————————

Interested in partnering with us? Join our investors list here.

Afford a Bull Market: Let’s Talk about Underwriting Rent Growth…

Rent Growth… another core element of CF Capital’s underwriting process. In this article we discuss why rent growth is important, how we factor in the metric, and what it means for other critical parts of underwriting.

First, let’s just establish that rent growth is a metric and is commonly shown as a percentage. Like the other metrics we have already discussed in previous posts (Vacancy Rates, Bad Debt, Cap Rates, and Interest Rates), we approach things from the top-down and then really dive into the fundamentals of properties.

By top-down, we mean starting at the “big picture” national level and working our way down to individual multifamily properties.

Rent growth is important to our process because it can make or break the decision to pursue a submarket and/or a specific property. This decision of course isn’t solely determined by this metric. We have to consider supply and demand dynamics (market absorption and expected future supply, for example) while synthesizing the market’s preferences and behavior.

From that point, we can make an informed and conservative decision to pass an opportunity or continue to pursue. Our proprietary business plans for those acquisition targets which we choose to pursue account for potential adaptations we might have to make if the market were to experience any radical change at some point during our hold period.

Nevertheless, let’s walk through how this is taken into account throughout our underwriting process.

We begin by gathering historical and current US rent growth data. From this information we can establish baselines for comparisons in our next steps of the process. These comparisons will allow us to identify things like: 1) the submarkets than contain properties that are attractive on a rent growth basis; and 2) any anomalies that make a submarket or property more interesting.

This top-down approach allows us to compare where the broader nation is in its macro cycle compared to the data we gather at the local submarket and property level.

If you were curious, the current national rent growth is -0.6%, slightly below the long-term historical average for the US multifamily market, ~2.6%.

With that said, our next step is gathering that same rent growth data of specific submarkets. After analyzing the current and historical numbers we can identify how a market’s historical return compares to that of the national average rent growth. While not a requirement, it would be ideal to invest in a submarket with rent price increasing at a rate higher than 2.4%.

However, this trait should not be considered alone because the behavior of rental price increases are different in every type of submarket. As a result, it is very important for us to dive deeper into historical data and establish where the submarket is in its cycle. If rent growth continues to show evidence of acceleration, it will help us to assume that a particular submarket is early enough in its cycle for us to be able to capture a longer part of “the market upswing.”

After we finish this step, we move on by gathering this same data for individual properties within the same submarket. We compare our findings to the broader submarket and seek out any anomalies that require deeper research.

Because rent growth can vary greatly across submarkets and across different properties within a submarket, it is critical that we understand the underlying “why.” Fundamental market forces driven by tenant preferences and behavior are a big part of this equation. If we understand the market and its innerworkings, we can be more precise in our projections.

It’s important to note that Our models can have a wide variety of outcomes if rent growth is adjusted even the slightest bit. With that in mind, our conservative philosophy will add a margin of safety and maximize our ability to protect our and our investor’s capital. If long-term rent growth is 2.6%, we might run through a worst-case scenario in our models where long-term average rent growth goes down to 1.6%.

We are aware that we are in extraordinary and continuously evolving times. And we believe that our diligent and conservative nature will serve us well both in the short-term as well as over time allowing us to outperform over our hold period.

____________

If you’d like to learn more about CF Capital, please check out our Company Overview.

——————————————————————————————————————————————————————

Interested in partnering with us? Join our investors list here.

Conflicts of Interest: Let’s Talk About Underwriting and Interest Rates…

This week we are covering another core element to our underwriting process, interest rates. Why do interest rates matter to real estate investors? How do we use the interest rate element in our investment process? What are the implications of current interest rates during the pandemic and moving forward? The goal of this post is to address these questions and many related questions.

First, let’s begin by defining interest rates. As it relates to multifamily investing, an interest rate is the amount charged by a lender to a borrower for the use of their fund.

If interest rates are low, a bank will earn less on an issued loan and a borrower will pay less to obtain a loan. When rates are high, a bank earns more and a borrower pays more.

For real estate investors this concept matters because it is obvious that when you want to borrow money to invest in a property, you want the least possible amount of money coming out of your “pocket.” Higher interest payments eat away at your net cash flow and investment returns. This is known as the cost of financing.

Interest rates also matter because any knowledge of past and current interest rates can serve as a tool in investment analysis.

At CF Capital, we look at various times throughout history when interest rates have fluctuated in a market cycle and observing the relationship to the economy, we strengthen our ability to approach an investment.

Our research can tell us where we might be in a market cycle. Because we can make an educated estimation on current times, we can further understand the potential outcomes of a certain scenario driven by market forces.

In terms of financing, we generally believe that low interest rates are good for us when we are only thinking about the negative effects on net cash flow by having to pay interest on a loan.

Holding everything equal, the yield on a property investment goes up when interest rates go down. A yield also becomes more attractive if it is higher than the treasury equivalent and provides cash flow that is more like a stock dividend. Let us provide a brief example.

Yield is defined as the difference between the cap rate and the cost of financing. If the cap rate is 5.0% and the cost of financing for a 10-year loan is 3.0%, the yield would be 2.0%. At this point in time, a yield of 2.0% exceeds the 10-year treasury yield of roughly 0.7%.

With that said, interest rates shouldn’t be considered in isolation. Rates are tied to other market forces that may lower or cancel out the positive impacts of falling interest rates.

In the current pandemic environment, the fed funds rate (i.e. the interest rate set by the US Federal Bank) has been lowered to historically low levels, 0.25%. One would initially anticipate that this would attract more capital to property markets, leading to some compression of cap rates. Compressed cap rates should increase property values given the NOI stays the same.

We are certainly aware that the pandemic creates additional uncertainty in our industry. We also understand that there are certain types of properties that are more sensitive to interest rate changes. Because of this, we remind ourselves to carefully consider properties and implement a business plan that reduces risk of interest rate (and economic) changes.

However, as we stated above, interest rates shouldn’t be considered in isolation. Also, it is important to remember that we do not like to speculate. We take into account what we know at the fundamental level, and apply it to a conservative, well-informed approach when underwriting.

Tying everything together, it should come as no surprise that we are actively seeking out investments with greater yield during this pandemic. Factoring in interest rates and other market forces, we continue to pursue the right balance of risk and return.

"Buy a stock the way you would buy a house. Understand and like it such that you'd be content to own it in the absence of any market." Although we are not investing in stocks, this same concept in the quote by Warren Buffett can be applied to what we do in multifamily real estate. While we have specific business plans that we intend to execute during our hold period, our thought process entering into every acquisition is that we would be comfortable owning it forever.

——————————————————————————————————————————————————————

Interested in partnering with us? Join our investors list here.

It’s All Relative: Let’s Talk About Underwriting with Cap Rates…

Another week, another opportunity to educate our readers. This week we are continuing the trend in writing about the core elements of underwriting by walking our readers through cap rates.

By definition, a cap rate (or capitalization rate) is a metric used in real estate to indicate an expected rate of return on an investment. To find out the cap rate of a real estate investment, you divide the net operating income (“NOI”) by the current market value of a property.

Now that we have defined the metric, the important area to address is how we use cap rates when we evaluate a property.

First, we would like to establish that we do not speculate on market forces that we cannot control. We believe that it would be extremely difficult to be certain that an investment is going to return 8% annually, and not 7%. As we all can relate to the shock and surprise of the current world we are living in, we must remember that nothing is a “sure thing.”

With that said, cap rates are used as a simple tool in our process for both screening and evaluation.

Our initial screening phase uses cap rates to quickly compare similar properties. What do we mean by the “initial screening phase?” From our two previous blog discussions, you learned that we begin our underwriting process from a broader market standpoint to submarkets (or cities), and then work our way to researching individual properties. To discover interesting submarkets, we gather cap rate data to discover areas that may have the potential for greater returns on an investment.

For example, one of the cities we are looking at now, has an average multifamily cap rate that is just over 6%. Compared to the broader nation that has an average multifamily cap rate just over 5%, we believe this area shows promise.

Once we look deeper into a submarket, we apply cap rates in our models to screen for properties that might be worth pursuing.

In our evaluation process, the cap rate is an output metric that we consider, but only after we solve for other important factors, such as cash-on-cash return (“CoC”), the internal rate of return (“IRR”), debt-service coverage ratio (“DSCR”), annual cash flow, the overall business plan, and many others.

In simple terms, we are able to figure out the cap rate once we have filled the gaps in our research process that will enable us to calculate it.

Every investment we make will require some sort of leverage. The amount of leverage is determined by how much cash we are initially investing. It is important to consider various scenarios to see how much income could be generated from a property from our initial investment.

Through our conservative approach, we can figure out the cash flow income from our initial cash investment (i.e. CoC). We can also figure out if the cash flow is at a level that will enable us to service the debt (i.e. DSCR), so that we can take on a certain amount of leverage.

After going through this process and factoring in the key variables, we are able to do a side-by-side comparison of the cap rate that was generated by our models to the cap rate of the broader submarket. This allows us to place the individual property’s cap rate next to a benchmark -- a part of our process that will help us determine if the expected rate of return is in the ballpark of where it should be (i.e. above the broader market’s expected rate of return).

The primary takeaway from this discussion is that cap rates are just a starting point in evaluating deals as there are many other factors to consider. Though we do not want to downplay its importance, it is only one part of the screening and evaluation process when we are underwriting properties.

A Current Liability: Let’s Talk About Underwriting Bad Debt

In our last blog post we mentioned that we would continue our dialogue with our readers. Our post this time will discuss another core element of our underwriting process, bad debt.

In the real estate universe, bad debt is the amount of unpaid rental income that is determined to be uncollectible. The term bad debt is often referred to or used interchangeably with “credit loss” or “collection loss.”

Bad debt is an adjustment line item to net operating income (“NOI”), and as it relates to our projections, this is an adjustment to potential operating income. In other words, the bad debt line item is a forward-looking provision, which takes into account probabilities and other statistical factors.

The primary thing that you should takeaway is that bad debt has an inverse relationship with NOI. An increase in bad debt causes a decrease in NOI and asset value. To determine more accurate outcomes of bad debt in our projections, let’s walk through our underwriting process.

Because bad debt is an adjustment to NOI just like vacancy, you may notice similarities to our last post (The Leased We Could Do: Let’s Talk About Vacancy Underwriting).

We begin our process by gathering national data from financial institutions for current and historic credit loss levels. By gathering data from ten years back or sometimes even further, we can formulate some sort of credit loss baseline average for the multifamily market. It also helps us to understand how the US multifamily market performed across market cycles, while taking special notes on the worst bad debt levels throughout history.

Applying our experience and knowledge of the multifamily market, we would immediately bring our attention to post-GFC (global financial crisis) because of its extreme impact on all real estate market forces.

At this point in time, our research has led us to assume that the ten-year national average for credit loss for multifamily real estate is roughly 0.7%. Due to the economic impacts of the COVID-19 pandemic, bad debt has doubled and continues to trend upward toward the highest historical levels (2.7% annually over a two year-period). This is important for our next step when we investigate and analyze credit losses in more specific areas.

After reviewing the regional and state data, we narrow our focus to an individual market.

Just as we did at the national, regional, and state levels, we collect current and historical data on our target market. The historical average establishes a baseline, the current levels help to gauge where we are in the market cycle, and the highest historical bad debt levels provide guidance in a worst-case scenario.

From our research, we gathered that the ten-year historical average of our target market was 0.6%. For Class B and C Garden Style properties the average was 0.5%. We also gathered that current bad debt levels have risen to 1.2% due to the pandemic, but have not yet reached their historic high point (2.6% annually over a two-year period). However, prior to COVID, our target market was trending downward, hitting a low point of 0.4%.

From this current information, we can see that our target market reveals signs of better health and overall resiliency relative to the rest of the nation. This is a good sign! It tells us that, aside from other market forces and economic health indicators, it would be wise to continue our underwriting process by moving to the next step in which we probe into individual multi-family properties.

Before we start our projections, we gather current and historical data on bad debt of our prospective properties. After analyzing these numbers and other relevant quantitative measures, we proceed by focusing on a property that provides initial evidence of a promising opportunity.

Our target is a Class B property and fits in the broad Garden Style category. It’s historical average levels for bad debt have been 0.4%, and before the pandemic, levels have been trending downward to a low point of 0.2%. We also see that current levels are 0.8% and that the historical high point was 2.9% during the global financial crisis.

Focusing exclusively on the bad debt metric, we examine the property for any anomalies. In this case, the one anomaly we notice immediately is the historical high level; at its worst, the property had higher bad debt levels than both the nation and its respective market.

Just as we would with any core element of our underwriting process, we seek to uncover the true reasons for an anomaly. What were the root causes for this anomaly? What were the market forces at play? Or was it something specific to the property and its management? In an attempt to address these questions, we research other factors such as location, vacancy rates, unemployment, and supply and demand levels of the respective market.

With regard to our target property, we have discovered that a lack of diversification in tenants and poor collection policies led to this anomaly. Given that our research has not identified any major red flags at this point, we believe we are ready to build out our models.

We begin by entering all of the data into our proprietary model. To the same degree as vacancy, our approach to bad debt is conservative. In our projections, we like to “think like a lender,” which means that we factor in current circumstances and the probability for extraordinary negative outcomes in the economy.

Due to the current pandemic, we believe there is a realistic scenario for an abnormally weak economy. We expect that one of the potential outcomes is higher-than-average levels for credit loss.

Our conservative philosophy causes us to handle our credit loss projections a little different; we add a margin of safety in our scenario analysis.

The projections of our current acquisition prospects consider historical highs and a buffer for any deviation from previous market scenarios. To rephrase, our projections involve a worst-case scenario that factors in an even higher estimate for bad debt. Typically we add a 1.0 to 2.0% margin.

As we make any other adjustments to a worst case scenario, we can begin to build a case as to why this deal would work or not. Part of that equation is seeing if a change to the financing structure, capital improvement, or insurance costs could push the deal forward.

It is worth noting that any discovery or projection is one of the deciding factors in trying to establish the type of loan we might obtain should we choose to invest in the property. Also, beyond financing structure, we take into account any data related to bad debt and formulate a strategy in our business plan that seeks to minimize credit loss. For the sake of maintaining our focus on bad debt, we will save a detailed discussion on those topics for another time.

Currently, our projections for this target property fit within our comfort zone. As a result, we have decided to move beyond the underwriting stage to our next step of the investment process.

——————————————————————————————————————————————————————

Interested in partnering with us? Join our investors list here.

The Leased We Could Do: Let’s Talk About Vacancy Underwriting…

In these interesting times, we are learning about the extraordinary generosity of people around us. We have found that people are sharing more than ever.

Witnessing this is a strong reminder that there is no point in possessing something valuable if you cannot share it. It is also a reminder that relationships are powerful.

With that said, and in light of the pandemic, we think it is important to continue our public dialogue with the CF Capital community by touching on some of the core elements in our underwriting process and how they apply to this environment.

The first element we would like to address is vacancy.

Our approach to vacancy is critical to our underwriting process as it allows us to learn about the health of a broader market as well as the underlying property performance relative to others in a city or town.

CF Capital’s vacancy underwriting process requires us to remain plugged-in, observant, and adaptable to the macro and micro forces at play, such as unemployment or market supply dynamics.

The beginning of our process investigates the historical and current performance of a market as well as evaluating a particular property to determine what is realistic and what is expected moving forward. We then gather the current and historical vacancy figures to compare the market to an individual property.

This also allows us to see market performance throughout cycles, gathering an average rate, gauging current trends, and formulating an opinion related to various potential outcomes. As we navigate these steps, we consider market forces and property-specific assumptions to determine the practicality of a projection.

In other words, our projections are based on actual data because we believe that history tends to repeat itself. Current and historical data also enable us to identify any anomalies, causing us to further examine an individual property. In such a case, we would perform additional due diligence to discover the origin of the anomaly. Possible sources might be the operating activity levels of the property manager or the market’s willingness to pay rent at current levels.

As we move onto the next step, it is worth mentioning that it is in our DNA to be consistent in the conservative nature of our underwriting process. Our general attitude allows us to take great comfort knowing that we are protecting capital by considering the worst case scenario, while remaining optimistic that a property will most likely perform better.

A conservative mindset also means that our approach does not speculate on the uncertainties (e.g. migration patterns) related to the future of a particular market. Instead, we stick with what we currently know and consider a thoughtful scenario analysis that includes a best-case and worst-case.

Typically, we apply a margin of safety in our projections by including a historic-low submarket vacancy rate. However, with the current pandemic environment, we might run a worst-case scenario stress test by adding a buffer to vacancy. We can then determine if a specific deal would still work by analyzing the impacts on our model in areas like net operating income, cash flow, and asset value.

Depending on what the projections reveal, we will either pass on the property or proceed with the next steps of our investment process.

To further illustrate our approach, let’s walk through a hypothetical underwriting process with a particular focus on vacancy.

Our process begins by collecting data at the national level. We have gathered that the ten-year historical average of vacancy for multifamily properties is roughly 5.0%. Currently, multifamily vacancy is below that level at 4.2%, with Class B properties at 4.2%, Class C properties at 3.6%, and Garden Style properties at 4.3%.

After looking into region-specific vacancy rates and other economic data, we discovered that one of the cities in the Southeast region had potential, especially in Garden Style Class B and C properties. We will refer to this city as City X. Multifamily vacancy in this city has been trending downward and is currently 3.0%, far below its ten-year historical average (7.7%) and significantly lower than the current national average. Unemployment levels this year have spiked from a 3.3% low in March to 9.7% in May, but have shown more resilience than the rest of the nation (13.3%).

Other economic indicators also suggest that City X is a compelling area for investment and relatively unpenetrated by other multifamily investors. Within City X we found a Garden Style Class B property in a desirable location with attractive characteristics, including a low vacancy level. The property has vacancies in 2.0% of its units (versus the ten-year average, 5.0%), and over the past ten years has shown stability with some evidence of mismanagement.

Proceeding to the more quantitative step in our underwriting process and taking into account the current pandemic, we factor in a unique worst-case vacancy scenario by adding a 2.0% margin of safety to the city’s worst historic level of 13.0%.

Applying a worst-case vacancy rate of 15.0% and considering our other assumptions, our projections determine that our deal could work. In this case and depending on other assumptions, we would likely proceed to the next step of our due diligence process.

——————————————————————————————————————————————————————

Interested in partnering with us? Join our investors list here.