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.

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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.

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CF Capital Participates in Kentucky CCIM Chapter’s Multifamily Panel

CF Capital Managing Partners Bryan Flaherty and Tyler Chesser joined other industry leaders in the Kentucky CCIM Chapter’s “Next Market Cycle for Multifamily Real Estate” virtual panel on July 10th.

The panel discussed potential migration patterns as it relates to the COVID-19 pandemic, Louisville’s Class A and B occupancies, debt market outlooks, cap rate compression, rent costs, 12-month forecasts of new multifamily construction, how Kentucky compares to other states in regard to multifamily trends, and more!

Video of the full discussion can be accessed here.

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

COVID-19 Update and Outlook

It's been quite an interesting few months, to say the least. We hope that you and your families are remaining safe and well during these unique times. Since we originally notified you of the launch our real estate investment firm, CF Capital, the entire world has changed in profound ways due to the COVID-19 pandemic in addition to significant cultural and socioeconomic events. While we’re certainly living through history and much has changed, and the environment is continuing to evolve at a rapid pace; however, our intent to provide stable and quality multifamily investment opportunities to people like yourself and our best in class team remains rock solid. Our focus remains on opportunities that provide capital preservation, cash flow and stability in both the current and future environments. The current macro environment has strengthened our beliefs in the fundamentals of multifamily real estate, the acquisition markets we’ve identified and the performance metrics of apartments as the preeminent investment vehicle in both times of excess and in times of economic challenge.

HOW HAVE THE RECENT EVENTS INFLUENCED OUR OUTLOOK?

When we launched CF Capital in January 2020, we felt very strongly this would be the best use of our time, energy and resources, because of how much we believe in the safety/security, inflation protection, cash flow, tax benefits, demographic and migration trends, patterns of rental by necessity and choice, the continued essentialism of housing, and the economies of scale in multifamily real estate while we put a best in class team on the field to execute conservative and realistic business plans. When we scan the economic and market landscape as a matter of realistic and eyes wide open evaluation, we are tremendously challenged to locate a better suited investment vehicle to participate in, now and into the future, with our own resources and alongside quality people like you. We continue to believe that multifamily real estate provides the most attractive average annual total returns of any commercial real estate sector coupled with some of the lowest levels of volatility.

Before the market adjusted due to COVID-19 we were in the midst of the longest economic expansion in American history. This economic expansion had created an extremely competitive market, however, at the time we launched the firm, we felt that with diligence and focus, a competitive advantage that includes extensive industry relationships and influence, we could thrive and provide outstanding opportunities for passive investors. We feel even stronger about this today with a shifting marketplace. While we are entering into a new market cycle, we’re remaining actively engaged in the rapidly shifting set of opportunities. What was previously a heavily weighted seller's market, is now shifting into balance and in many ways even more so a buyer's market. With this, our team is uniquely positioned to acquire attractive deals and provide not only a safety mechanism in our portfolios, but also opportunities to create long term value, capital appreciation, and cash flow.

WHERE DO WE GO FROM HERE?

We’ve been actively seeking opportunities in this new landscape and we wanted to touch base with you to let you know what we’ve been up to. While deal flow dropped off a cliff early on in the COVID-19 pandemic in March, things have picked up as of late. The slowdown in deal flow has been due to seller’s unwillingness to adjust fundamentals and operating assumptions to a post COVID-19 environment. While buyers, including ourselves, began underwriting differently with a “forward-looking” approach, sellers understandably took a “backward looking” approach with pre-COVID pricing expectations in their minds. We are underwriting rent growth and vacancy differently in this post-COVID world to adjust for changing dynamics. Additionally, many lenders are requiring new principal and interest reserves they were not previously requiring, meaning we need to bring more equity to the table. All this together means that if our investment yield return expectations don’t change (they haven’t) then that means something must change – PRICING.

So how does this influence the buying opportunities today and into the future? Do we expect widespread distress similar to the Great Recession? Probably not, at least in multifamily. Will the current environment present situational distress? Yes, we believe so and feel that opportunities are presenting themselves today. On the opposite side of any crisis is opportunity.

We’ve been aggressively underwriting deals across our target markets and have several that are under serious consideration. We’ve been engaging with our teams from the financing, management, and tax perspective to ensure our assumptions are not only realistic but achievable taking into account the potential of an extended challenging operational environment.

Some investors have said “pencils down on underwriting any new potential acquisitions – be careful not to catch a falling knife.” We are holding that thought in our minds while also having an understanding that we live in a tremendously complex global environment and we cannot generalize on any policy or outlook. We’re cautiously optimistic that the future is bright, and at the same time, we’re considering the fact that rents may remain flat for a period of time in many of the markets we’re considering (as well as nationally, for that matter) and we’re hyper-sensitive to the fact that jobs are the driver to success of occupancy and demand metrics. With about 13-15% of the labor force (depending on the data source) currently categorized as unemployed, a vast increase from the historically low 3.5% in February, we are absolutely aware that value add propositions will not only need to be delayed but also certain operational expectations tempered. We do not live in the prior environment and what worked then will not necessarily work now. We do not have our head in the sand. You can be confident knowing that our property-level business plans will include goals and objectives that account for the macro-economic influences currently at play.

With that said our investment thesis remains the same - focus on quality assets with affordable metrics – B or C assets in A and B locations. We want to provide our tenants a nice, safe, clean place to live and add value to those tenants along the way. As you know, we are primarily focused on secondary markets because we are yield driven and we like to deliver Cash-on-Cash returns and current income to our investors. This makes our approach sound not only in this market but market cycles to come.

IN CLOSING

With all of this in mind, we remain aggressively patient. We respect you and the future opportunities that we will create together, for what makes sense for you and your families. Stay tuned for opportunities to participate with us as we continue to work hard on sourcing attractive deals. The next several years will be one of the greatest opportunities of our lifetime to not only capture opportunities for you, our partners, but to make a great impact on the communities in which we are involved in the process, and to be a part of progress and a better future for our residents and employees.

On behalf of our team and our families we wish you well and look forward to collaborating in the near future and well into the next phases that await us. Thank you for your continued support and please feel comfortable reaching out to set up a call with either of us (Tyler or Bryan) to discuss anything further, and certainly check out our website for more information on what we’re up to.

Let’s be great. We're absolutely better together.

In Partnership,

Tyler Chesser, CCIM
Bryan Flaherty, MBA
CF Capital

P.S. Join us and RSVP here on June 18th from 5-6:30pm ET for the Louisville Multifamily Mastermind Sponsored by Park National Bank and our guest speaker, Market President Andrew Holden - live on zoom.

P.S.S. You’re invited to listen to Elevate, the masterclass where we dissect the elements of exceptional achievement and lifestyle design with a focus on personal growth and real estate investing.

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