Emotion Picture: Let’s Talk About Keeping Emotions Out of the Investment Process…

You cannot have a good strategy without good behaviors, like emotional discipline.

“Only when you combine sound intellect with emotional discipline do you get rational behavior.” – Warren Buffett

Have any of you let your emotions get in the way of making a better decision?

Whether the situation was big or small in significance, I imagine the answer is “yes” for everyone.

Regardless, our point is that emotions can affect the way we make decisions.  And when it comes to investing, the same concept applies.

For our discussion today, we would like to review the impacts of emotions on the investment process and our ability to effectively execute a strategy.

Strategy and Emotions

So how do emotions apply to strategy and what part do emotions play in determining a good strategy? 

First, a strategy at the most basic level, according to Richard Rumelt, is “a choice” related to the “application of strength against weakness, or strength applied to the most promising opportunity.”   

In order to execute, a strategy requires resources, processes, and people.  To successfully execute, you need a good strategy, which is made up of better information, better analysis, and better behaviors.   

That’s right, the last part of a good strategy is behaviors.  So, I think you all can probably guess where we are going with this.

You cannot have a good strategy without good behaviors, like emotional discipline.  For the sake of our argument, let’s focus on how emotions apply to the ability to execute an important requirement of our strategy, the real estate investment process.

Emotion as a Liability to the Investment Process

If you are not disciplined with your emotions, they become a liability to the investment process, and, in turn, a liability when attempting to successfully execute a strategy.   This is deemed a liability because without discipline, your decisions are guided by emotions rather than the objective nature of facts.

We are aware that emotions are natural.  We are humans after all.  Emotions in our everyday life are an expression of who we are and what we value. 

We are not saying that we aren’t supposed to feel emotions, and we certainly are not saying that CF Capital will never show emotions during our investment process.  However, we are saying emotional triggers can be recognized when circumstances arise, which gives us the chance to handle our behaviors accordingly.

The circumstances when emotions may become a liability come in a wide variety.  Also, every person handles emotions in their own way, so there are no perfect general rules of thumb. 

With that said, we believe the best way to discipline your emotions is to really understand the potential triggers that cause a case where you get lost in your own emotions.  In doing so, you can minimize how much negative impact your emotions have within your investment process.

Examples of Triggers

Lack Self-Awareness - Do you tend to be a negative person and find all the weaknesses in a deal or circumstances in general? Or does your positivity blind you from potential risks? How do you handle setbacks? Are you someone who has a low emotional boiling point?

Succumbing to the Forces of FOMO - Do you feel a need to immediately jump into real estate investing because you missed a “great opportunity?” Do you find yourself saying, “I’m not expanding my portfolio fast enough”?

Investing with Your Ego - Do you personally tie your self esteem to the value of your investments? Are you comparing your investment success to others? Do you find yourself saying you’re better than other investors and you can handle riskier investments?

Misunderstanding Growth - Do you understand the difference between controlled, steady growth and rampant growth? Steady growth can be maintained without destroying the integrity of your systems and allowing you to stow away enough cash for a rainy day, improve systems, and strike when a good deal appears. Or are you driven by the latest “game changing” fad and are you willing to risk it all for a short term gain?  

(check out related ELEVATE podcasts with Lisa Feldman Barrett, Marc Brackett, and Dr. Jud Brewer).

Looking Outward - Are you investing in a given market because Fred down the street recommends it? Do you know Fred’s investing goals? Is Fred down the street following the same investment criteria as you are?

Thinking Real Estate Investing Solves Everything - Do you believe investing in real estate will help you solve your personal problems? Are you telling yourself the grass is greener in real estate investing because you can run away from your problems? Do you think you won’t have to work anymore once you begin investing in real estate?   

Closing Thoughts

Keep in mind the things that we can control and the things we can.  We can’t control the market or everything that happens to an investment property, but we can control how we react to those situations. We can’t control that the human life is filled with a myriad of emotions, but we can control the way we behave based on being emotionally intelligent and separating perspective from raw emotions. We remain committed to making wise, long-term investment decisions based on data and principle, not how we feel in the moment. We encourage you to proceed with investing amongst your own sea of emotions wisely!

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

 

 

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.

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

 

 

It’s Time to Make Time: Let’s Talk About the Importance of Time Management…

 

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“Procrastination is not a time-management problem, it’s an emotion-management problem.” - Tom Pychyl

“Time is really the only capital that any human has, and the only thing that he can’t afford to lose.” - Albert Einstein

No matter how much work we put into productivity, somehow it always feels like there is so much to do and never enough time in the day to do it.  But why?  Is it because there is really so much to do? Or are we not managing time effectively enough?  The rule of 168 reminds us that we all have 168 hours each week.  Some of it’s spent sleeping, keeping up with personal hygiene, spending time with family, and some of it’s spent for professional endeavors.  The question is, how are you maximizing your 168 hours each week?

In this discussion, we dive into how to manage our time, because time management is life management.  The more we take control of our time, the more we are taking control of our lives.  Further, the more we’re managing our time appropriately as real estate investors, the more optimal our results will be.

But before we get to the particulars of it, let’s discuss why time management is important.

Time Management & Stress Reduction

When we take control of our time, we are sending a signal to ourselves and those around us, that we respect our time and we respect ourselves and by doing this we reduce anxiety.  We feel like we’re in the driver’s seat, rather than reacting to what’s thrown at us.  The more we manage our lives, the less chaotic we feel, which puts us on top rather than grasping at straws, which can make us feel helpless.  The less stressed we are, the more productive we are.

WFH Time Management

Managing Time When Working From Home

When working from home or remotely, it’s even more important to manage time effectively, otherwise it can lead to burnout as well as being ineffective.  The lines between work and personal are extremely blurred when working from home.  If you work from home, gone are the days where you left the office at 5pm and work was finished until 9am the following day.  If we don’t take control of our time, then we can end up always working, which is unhealthy and ultimately doesn’t produce the best work.

There are various ways to manage time at home, for example:

  • Create a distinction between the office space and personal space and don’t work in the personal space.  This can be in the form of a curtain, or a barrier or even a line down the room

  • Close the laptop and the phone for an hour during the day and go for a walk

  • Have strict rules about working during meals (don’t do it!)

  • Have a firm cut off time at night and start time in the morning, where unless it’s an emergency you will not cross that line

  • Most important: Communicate all of this to everyone in the house, so each of you can hold the other accountable

Now what are some actual best practices that we like to follow?

1. Create a System That You Enjoy Using and Looking at

The best way to manage time effectively is to create systems that work for you and make you feel good every time you look at it. 

If you like ‘old fashioned’ pen and paper, then put your to-do list on that.  If you enjoy apps, or want everything in your calendar, that’s fine.  The important thing is that you need to like your system so that you engage with it and don’t run from it. 

If you don’t like the system you’re using you’ll resist opening it and using it, which will work against you being productive.

2. Be Realistic

It’s one thing to want to get everything done, it’s another to be realistic about what you can do and the time frame you can do it in.  Managing time effectively, means managing expectations realistically.  

One way to do this is by taking the task at hand and figuring out how many hours it’ll take to get done.  Then break down the hours per day, doing a bit of work each day until the task is complete.

For example, if you have a large project that you think will take about ten hours to make a dent in, look at your calendar and figure out when you can realistically dedicate those hours. 

Can you do two hours each morning for the next five days?  Can you do one hour for ten days, or three hours over the course of three weeks?  Be realistic and then commit to what you decide to do.

3. Work When You Work Best

It’s not enough to have a to-do list, but you have to carve out time in your day to focus on that list, at times that make sense for the task at hand.

For example, if you have a project that requires a lot of concentration and you are at your best in the morning, then carve out time in the morning to do that project.  Even if it’s just three hours, work on things when you are at your best to work on them.

Don’t just put it on the to do list and assume you’ll get to it at some point.

4. Have a “Filler” List

There are always breaks in the day from the more intense work and when these breaks occur, one of the best ways to increase productivity is by filling that time with a few lighter things on the to-do list.  Some people call this the ‘filler list’. 

These are things that need to get done, but perhaps don’t need hours or a quiet space. Maybe it’s sending a few text messages or answering emails or making calls you’ve been putting off.

Think about all of the 15-20 minute chunks of time you have in the day.  If you add it up, there’s at least 1-2 hours where you could be ploughing through a ton of things.

5. Break it Down

Part of the reason we do not have effective time management is because we often don’t want to do a task that seems too daunting, so we hope it goes away, or we put it off, or we put it on the list as a whole project, but then never get to it. 

This leads to procrastination and experts tell us that procrastination is more emotional than it is logistical.

We procrastinate when we get overwhelmed or anxious and one way to combat this is by breaking things down into baby steps and asking ourselves: What’s the next step? When we do things one step at a time, it helps move us forward and take actions that eventually build momentum and ease that feeling of fear and anxiety.

“Procrastination is not a time-management problem, it’s an emotion-management problem.” - Tom Pychyl


Main Takeaways

Time management is both practical and emotional, which means that we have to keep our mental and emotional health in check.  The more conscious we are about what works for us and how and when we work best, coupled with taking stock of how a task or a job is impacting us emotionally, will help us take more control of our time.

The more we take control, rather than letting our time control us, we’ll be more productive and feel more fulfilled.

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

 

  

Calling All Ideas: Let’s Talk About Off-Market Deal Sourcing…

 

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“Remain top of mind. Check in with owners every 3 to 6 months. Establishing a relationship is important, but it’s even more critical to nourish that relationship.”

Real estate is both a local and relationship-driven business. When looking for operating partners, CF Capital seeks teams who exhibit niche business strategies in well-defined geographies, local connectivity, micro-market knowledge, and a proven track record of successful execution.

The local focus and niche strategy enable operators to source coveted ‘off-market deals’. In this post, I want to explore some of the strategies around off-market deal sourcing.

Before I get into the actual approaches, let me reiterate that these are only effective if you have a niche investment strategy, geographic focus, and history of successful execution. Without that, these strategies are meaningless.

Target deals with (a bit) more hair on them

Down the middle deals that fit the box of a large majority of the buyer pool are unlikely to trade off-market. Instead, target deals that have some inherent complexities; significant deferred maintenance, a loan that needs to be assumed, or an affordable component. Complexities lead to a smaller buyer pool and more favorable pricing.  Being in the business of problem solving leads to more opportunities.

Work with brokers who are not necessarily given the labels as the top brokers in their market

While it’s important to have relationships with all the major brokers, you’re sometimes likely to access off-market deals through smaller boutique brokers who have relationships with the local “mom and pop owners.”  Communicate what you’re looking for and let them go to work.  What may be a small deal for the national or regional flag firm could be life-changing for a local broker who will roll up his or her sleeves on your behalf.

Know the motivations of the seller at the asset and portfolio level

The more you know about the seller and their motivations, the more effective pitch you can make. By understanding their asset-level strategy, hold period, portfolio strategy etc., you can tailor your pitch to align the motivations and create a win-win scenario.  Among the first questions we ask when looking at a new deal is, “Why is the seller considering a sale?”

Consider running 3rd party due diligence before the contract is finalized to condense the closing period

The key to executing off-market deals is surety of close and execution timeline. Consider spending money up front to conduct diligence while the Purchase Contract is being finalized. This will ensure there are no timing issues and you’ll be able to close within the contract timeline without exercising an extension. The shorter diligence and closings periods may be what separates you from other potential buyers.

Relationships, credibility, and reputation are everything

Always do what you say you’re going to do. Pay brokers quickly and don’t haggle them about their fee. Don’t re-trade deals (unless there’s a valid reason, and something material has been misrepresented or due diligence revealed an inherent flaw). Make sure you have the necessary access to debt and equity. Credibility is everything.

Think like a seller and understand the depth of the buyer pool

In order to curate your pitch, you need to understand both the motivations of the seller as well as the likely competing buyer pool. This knowledge will ensure you put your best foot forward without negotiating against yourself. This gives you a clear sense of reality when making an offer, negotiating an agreement, and managing a transaction towards acquisition.

Consider strategies to close on loans more quickly

Make sure you have good relationships with the active lenders in the market. When an opportunity comes up, you need to be able to move quickly. Debt is one of the longer lead time items (not to mention a key factor of risk/return), so make sure you have a roster of active lenders who want to work with you and can mobilize quickly.

Brokers are motivated by the path of least resistance, not maximizing price

An extra $50k in sales price may be meaningful for the seller, but it may not be for the broker. Broker’s, usually will be motivated by the path of least resistance. They want to work with buyers they know will close and require minimal effort and risk for their client in selling to you. Position yourself to be that buyer who talks the talk and walks the walk.

Find privately owned deals with aging owners

Although the multifamily real estate business has become increasingly institutionalized, many properties are owned by generational families, or mom & pop owners. Look for deals that have aging owners who may just look to get out of the deal so they can retire. These owner’s may be less concerned about maximizing price and don’t want to deal with the headache of a mass marketing process. Along the same path, look for deals that haven’t traded in a long time. These deals usually have private owners and are in need of an infusion of capital.

Educate the market about your investment strategy

Meet with everyone in the market and tell them what you’re looking for.   Be specific about your strategy and history of execution. You should be the first person they think of when they come across a deal that fits your profile.

Network relentlessly with owners, brokers, and lenders

You never know where your next deal is going to come from. Meet with everyone you possibly can. Communicate the success of your strategy, and how precise it has been in specific terms. . Find ways to add value to other market participants. Do this every day.

Remain top of mind

Check in with owners every 3 to 6 months. Establishing a relationship is important, but it’s even more critical to nourish that relationship. Check in frequently by adding value so you remain top of mind when an opportunity does arise. Consider hosting a golf outing or other similar event and inviting all the brokers in the market. When working on a specific deal, hang around the rim. We’ve closed on several deals recently that we started looking at years ago. Today the timing may not be right, but when the seller does decide to exit, you’ll be the first call. Further, if another buyer beats you to the punch, the deal isn’t done until it’s closed - stay ready.

Capital gains taxes could be a bigger concern than loan maturities

You could target deals with upcoming loan expirations as a strategy, but a bigger concern for sellers is often capital gains. The market for debt today is robust and during the last downturn many lenders extended maturities, so loan maturities are less of a risk. Be flexible and find ways to work with seller’s who are doing 1031’s.

It’s really challenging to source off-market deals, but there are many strategies to improve your chances. The most important aspect to deal sourcing is having a proven execution of a niche investment strategy and relationships.

It’s also worth noting that just because a deal was sourced off-market, that doesn’t mean it’s necessarily a great opportunity. This might be the most important sentence of this entire blog post. Don’t be fooled by perception!

So let’s now look back and ask, “how will you go about finding exposure to off-market deals?”

We can’t say it enough, please don’t hesitate to reach out to us to learn more about what we can do for you, even if it is just a friendly conversation about off-market deals (we love this stuff)!

In summary, we invite you to employ these strategies in ways that you find most valuable for your real estate investment goals. Further to that, or if you’re hard pressed to find the opportunity to integrate these strategies within your existing responsibilities, we invite you to invest alongside our team that executes these strategies on a daily basis. Click here to begin your journey of becoming a passive investor with CF Capital. 

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

 

  

2-Way Streets: Let’s Talk About Partnerships…

“If everyone is moving forward together, then success takes care of itself.” - Henry Ford

Recently, we talked about team building, and partnering with the right people (internally and externally).  We would like to extend that discussion by providing more general thoughts as well as more specific thoughts on “partnerships” and investment partners.  After all, relationships are a central theme to success in real estate investing, at least they are for our team at CF Capital.

First, let’s just start off by saying, we actively seek out partners who get that we are all rowing on the same team and working towards the same goals.  One of the goals we like to focus on is continuous and never ending improvement -  or more simply put, getting “better.”

One way to get better, of course, is to find other people to learn from and with.  At CF Capital, we actively seek out and build relationships with givers whom we adopt almost as if they were family.  As we grow the CF Capital team, we continue to look for great culture matches who are naturally curious and embody a deep sense of intellectual generosity.  

Across the CF Capital ecosystem, we actively invest in connecting people and creating a network that generates positive spillover (almost viral) effects, which we believe to be self-reinforcing.

We intend to build our firm as a long-term partnership with our investors and other business partnerships -- a view that each and every relationship is important to the DNA of the firm.  Our favorite length of partnership is "forever."  It’s not infrequent that we will mention the phrase, “we’re in the business of long term relationships.”

Anyway, to avoid making this post overly complex and to leave this topic more open-ended, here’s a list of five areas that we think must be acknowledged to make ensure a good business partnership is in place: 

  1. We are all different - No single person has it all figured out (and yes, that includes you, too). Varying skill sets, perspectives, and experiences working in unison are much more powerful than a singular paradigm.  In mathematics, 1 + 1 may equal 2, but in human interaction, 1 + 1 often results in 3 or more! We’re big believers in exponential results. Exponential results come from exponential thinking and thriving partnerships.

  2. Humility - This one is a tough one for many people (especially those type A’s).  None of us are right all the time. When we embrace the input of other people, whether we agree or disagree, it gives us the opportunity to see things from a different perspective. Furthermore, it is not always about who’s right or who’s wrong, more often than not it is about doing what is best in a given situation.  In many cases, this is usually the result of meeting in the middle.  Additionally, we’ve found that often the smartest people are truly the most humble. Success leaves clues.

  3. Integrity - If any partnership is going to work, it must be built on trust. Trust leads to respect, which creates a strong foundation to build upon.  No partnership can survive if there isn’t open, transparent communication with the spirit of vulnerability.  There’s a reason this is one of our core values.

  4. Teamwork - Partners must work together towards a common goal.  Whether this is repositioning an underperforming apartment community or business partners working to grow a business, there must be a unified vision that propels the group forward.  This unified vision must be created at the beginning. It may change over time, but everyone must be on board.  The lack of a shared vision and focus on unity has unraveled many partnerships.  There will always be differences of opinion on some things; however, there must be a core that unites.

  5. Passion - Partners must be passionate about working together and truly believe that they are better together than on their own.  This is the result of the foundation built by the preceding elements of a strong partnership.  Great partnerships usually result in the collective creation of something greater than themselves - something more impactful.

People are people. There are natural ebbs and flows in any partnership (business, marriage, projects, etc). There will be times of agreement, disagreement, disappointment, euphoria, and just about all elements in the gamut of human emotions. Building a solid partnership will help you weather the ups and downs to build something great together. Having a mindset of “playing the long game” can help you put challenges or victories into further context. Embodying gratitude for the continued growth experienced along the way, regardless of the event, is incredibly valuable as well.

With all that said, this is a topic that we are particularly passionate about, so we would like to continue our discussion related to partnerships on a future (near-term) date.  

Please stay on the lookout and stay tuned!

As always, if you have any questions related to this post and/or partnerships, our doors are always open!  Comment below, share your thoughts with your network via social media.

Lastly, if you’d like to explore partnering with us at CF Capital on a future real estate investment, don’t hesitate to click here to be notified of future opportunities.

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

 

 

Eat, Sleep, Invest, Repeat: Let’s Talk About the Benefits of Passive Investing…

“No matter how hard you work, your money can work harder.” -Aya Laraya

At least once in your adult life, I am sure you all have heard someone say, “Don’t work for money, make money work for you,” (or some variation of that).  For those who have and even more for those who haven’t, we would like to discuss this topic in our post today.  Passive real estate investing.  

What does that have to do with “making money work for me?”  Let’s start with the basics.

What is Passive Investing?

Passive investing refers to having an income stream that seemingly comes to you automatically. First, you make an upfront investment with your cash.  Then you receive a stake (in the form of ownership) in that investment, from which you are paid dividends or other types of regular income distributions.

This is passive investing because you are not directly managing the investment. It’s exactly the type of opportunity we offer with our investments at CF Capital.

Passive Real Estate Investing

Taking into account the broader passive investing explanation, passive real estate investing happens when you invest your cash into a real estate venture; one that you won’t be managing directly. Again, it’s precisely what we do at CF Capital. If you want all the benefits of investing directly in real estate without all the hassle or the tremendous effort in coalescing the team to do so, we invite you to consider investing alongside our team. 

There are several ways you can passively invest in real estate: syndications (see our posts on syndications and accredited investors), equity funds or ETF’s focusing on publicly-traded companies whose primary business is real estate, direct investments in individual publicly-traded real estate business’ stock, REITs or real estate investment trusts (both private and public), fixed income securities, crowdfunding, private equity real estate funds, and derivatives with exposure to the real estate market (e.g. swaps on residential mortgage-backed securities or RMBS).  Each of these requires a specific level of “knowledge and sophistication,” so not all of these are available to everyone.

You can passively invest in real estate with different intentions; all of which have to do with your individual goals. For instance, you can invest for passive income.  Typically, this income is paid out to you as regular dividends (in an equity investment) or as fixed income translated from interest payments in a debt-related investment. 

Also, you can passively invest in real estate for growth purposes.  This just means you may or may not care about passive income, and the main focus is the appreciation on the property (or properties) within the investment, followed by the profit when they are resold (i.e. the investment is liquidated). Everyone’s goals are unique, and each unique goal matches a corresponding strategy. For us to be a good fit to partner together, we must understand your investing goals and intentions before making an “offer” to invest together.

Now that we have reviewed some of the basics, let’s review just how great passive real estate investing really is.

The Benefits of Passive Real Estate Investing

If you are looking for a passive income stream, real estate can be one of the best passive types of investment you can access.  To keep things simple, let’s just say that it is important to understand that passive real estate investing can be an excellent option for adding to your residual income.

Residual income refers to the income that remains for an individual or a business after all debts and expenses have been paid. In layman’s terms, cash flow. 

To determine if the benefits appeal to you, here are five specific examples: 

  • Keep More Through Tax-Deferred Structures - In an equity-structured investment, passive real estate allows tax-deferred cash returns that can let you keep more of your earnings.  This is one reason we stated earlier that real estate can be a more powerful passive investment than other forms of passive investing. Unlike interest payments or stock dividends, which can be taxed at your highest income bracket, the pass-through potential benefit of real estate ownership allows your share of the depreciation expense to offset your income.

  • Keep More Time with Less Pain - When you are a passive real estate investor, you do not deal directly with the hassles of day-to-day-management. Leaky faucet? You’re not getting a call at 2am. Broken gate? It’s not your responsibility to call the handyman.

  • Keep Your Sanity: Less Lender Interaction - Working with lenders to obtain financing is difficult. Since the economy went south, banks have started to require even more documentation to get loans, and the process is both time-consuming and mind numbing.  When you are a passive real estate investor, your investment is tied to a professional private real estate investment company that already has relationships with select institutions. They navigate the lender financing waters on your behalf so you don’t have to.

  • Keep Your Time and Let Experienced Experts Take Care of it -  You always have the option in any investment to go it alone, whether that means investing in stocks through an online brokerage or buying your own investment property. But there is something to be said for leveraging the intelligence of the people around you.  Some real estate investors devote their lives to learning the in’s and out’s of the market, and passive real estate investing gives you the chance to benefit from their deep education.

  • Keep Your Bed Time: “Make Money While You Sleep” - Passive real estate investing can be quick. You do your due diligence, sign legal paperwork online and transfer funds almost immediately. And as soon as your investment is processed, you become an equity stakeholder in that real estate venture and can start possibly realizing passive income and/or a portion of that venture’s growth.  In other words, you have the potential to make money while you sleep. Primarily when investing in properties with existing tenants where there is existing cash-flow, your money is working for you 24/7.

But, What About the Risks?

Now that we talked to you about the benefits, how could we leave out the risks? All investments come with inherent risks, and passively investing in real estate is no different. To simplify this topic, here is the main point:

  • There is a Chance that You Lose Some or All of Your Money -  We apologize if that sounds harsh, but the reality is that nothing in life is guaranteed, not even real estate investments.  In the case of real estate stock, REIT, syndication, derivative, or fund investment, you can lose money when the value of the investment goes down.  Sometimes it may be due to internal issues with the real estate management team.  Sometimes it might have to do with the underlying asset (e.g. the company whose shares you’ve purchased, or the real estate portfolio of the REIT or fund), or due to a real estate market downturn.  In any case, the value of your investment could decrease.  From our experience and based on the data that is publicly-available, losing all of your money is not extremely common, but it has happened.

With that said, we would like to stress how important it is for you to do your own research or consult other experts/advisors ahead of time.  No real estate investment can promise you a return or protection of your investment (i.e. the principal).

Your own due diligence can never hurt, it will only help.  In doing so, you may even find “safer” or even more lucrative investment opportunities out there in the marketplace.

Final Thoughts

Regardless of whether or not you choose to passively invest, even if it is not in real estate (with our team or with another operator who may be a better fit for you), we want to be here for you all as a guide and as a potential solution.  Our doors are always open and we welcome any and all discussions related to this topic.  Seriously, we love it… almost too much!Ultimately, our team provides asset management solutions and a team of experts that give people like you access to high quality passive investing real estate opportunities. We’re positioned to help investors maximize returns, and mitigate risk all while generating residual, and predictable cash flow. If that sounds like something you want more of, feel comfortable reaching out. 

Please feel free to contact us through our inquiry page or reach out to us directly via email.  We look forward to hearing from you! 

“Rich dad said that financial intelligence determines not so much how much money you make, but how much money you keep, how hard that money works for you, and how many generations you can keep it.” ― Robert T. Kiyosaki

Recommended & Related Elevate Podcasts

(PRO TIP: Scroll down on our Elevate Podcast page, hosted on the CF Capital website to find the section titled, “Search Episode Transcripts.”  Type in the keyword “passive” to see all podcasts that touch on passive investing)

Recommended Books

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Team Sport: Let’s Talk About Building a Core Real Estate Team…

“Great things in business are never done by one person.  They’re done by a team of people.” - Steve Jobs

Just the other day, we were talking to one of our colleagues about scaling his business.  He was discussing his current struggles with his workload and has placed hiring as a top priority.  

Given our love for that kind of stuff we offered some very brief (and basic) advice to him: “Remember, it’s not WHAT [you hire], it’s WHO.”

Which brings us to our topic today.  The recent conversation inspired us to write about our approach on building a real estate team, an extremely important area.  And we’re not just talking about hiring internally.  We’re talking about collaborating with individuals and businesses that will help us succeed with our investments and day-to-day operations; both internal and external. After all, this business is without a doubt a team sport, and this topic is critically important to making a significant impact and reaching meaningful goals.

None of this is rocket science, but a methodical process paired with thoughtfulness and craft is the recipe we employ towards this end of strengthening our team

So where do we start?

Building the Base: The Extended Team and Identifying Needs

To kick things off, it’s important to know what it takes to build a fully functional multifamily real estate investment operation. 

Just like any industry, it’s recommended to cover all core verticals of the business: Operations, Sales & Marketing, Finance, Technology, and Production.  

Production, for illustrative purposes in this case, is a broadly used term to define the department that is core to the existence of any product or service offered by a business.  For us, our production team is our investment team.  At a very basic level, CF Capital “produces” a (financial) service of managed multifamily real estate investments and offers it to a broad marketplace of qualified accredited and sophisticated investors.  

From these verticals we can break things down further into key areas of responsibility:

Finance

  • Sourcing and managing the debt leveraged to acquire a real estate property 

  • Overseeing and managing all company funding and finances

  • Managing the books through accounting methods and principles

Operations

  • Dealing with legal matters and compliance 

  • Improving, maintaining, and securing the asset and the company’s entities

  • Interfacing with technology providers and vendors

  • Implementing and maintaining checklists and standard operating procedures

Sales & Marketing

  • Marketing investment opportunities to the investor market (i.e. business development or fundraising)

  • Contributing to the efforts of tenant occupancy levels, as well as managing the (potentially new) brand and the sub-market’s overall awareness 

  • Leading education based marketing efforts through mediums such as email, social media, website, blogs, podcasts, video series, print materials, meetups, etc.

Technology

  • Implementing systems (hardware and software) to improve and streamline operations of a real estate property

  • Leveraging technology to optimize our (CF Capital, the investment manager) business’ efficiency

Production

  • Managing an entire business that revolves around investment partners on all sides of the multifamily real estate investing company (tying things together with the investment management service offered)

  • Operating and (strategically) executing a the requirements for an effective investment department

Now that we have identified the key responsibility areas, it is time for the reality check.

First things first, know what you cannot do in terms of capacity, and know what you are not best suited to do, based on your talent, disposition, and interest level.  Also, right in the middle of the spectrum, one should address the areas where experts with a specialty or focus would probably do better.  To paint the picture, and not go overboard with the details, we have provided examples of the personnel needed for three business verticals -- finance, operations, and sales & marketing.

In the finance department, a real estate investment management company will need a:

  1. Lender: This is self-explanatory -- the lender is the party that provides the financing, typically in the form of a pure loan (i.e. debt).  A lender may be a government-sponsored enterprise (“GSE”), an international or national bank, or a third party lender.  A third-party lender would most likely be utilized if the normal GSE or bank qualifications are not met (see our post on Financing Secrets for additional information) for the purposes of a temporary bridge loan, and the source of third-party loan may be an individual or a group of individuals, but most often the loan would come from some sort of a financial services firm.

  2. CPA/Accountant: This may or may not be a part of the property management team

  3. Insurance Broker: This party proposes and connects you with the proper insurance to cover your property investment.

  4. Investments: This can be done internally with outsourced extensions as needed (e.g. for due diligence or quantitative purposes).

  5. Broker: A partner (new or existing) that manages a real estate property sale and is often involved in the sourcing of new property investments.

  6. Title & Escrow Company: This is the party that takes care of the formalities dealing with the sale process and owning the property.  In this case it would be the verification and transferring of title, as well as holding of the cash in escrow during the signing/sale process. 

For operations, the following are the main parties (note, there is some personnel overlap with the finance department):

  1. Property Manager:  The property manager and it’s extended team members run the day to day operations of the property and assist us with implementing our overall business plan..

  2. Attorney:  The attorney is involved with everything from the sale and purchase to the regular legal dealings of managing a property investment. 

  3. General Contractor:  A general contractor is an excellent party to “take care of business,” especially with any renovations or enhancements to the property.

  4. Investments:  The investment team must also coordinate with the on-the-ground operations teams (e.g. property manager) to make sure the investment is executed according to the business plan.

  5. Photographer:  Although a seemingly more “minor” role, the photographer is used for a number of things: from the due diligence process before the sale, to the ongoing marketing and advertising of the property.

As with the operations department, the sales & marketing department will have some overlap with the other departments in terms of personnel:

  1. Property Manager: The property manager’s team or the team that is hired to be on-site (e.g. superintendent, leasing office staff, etc.) often can run the marketing and advertising process sufficiently to maintain/expand occupancy levels.

  2. Marketing/Advertising Team:  This can be in-house or a third-party marketing agency to aid in anything from a rebrand to general market presence (e.g. digital advertising).

  3. Photographer: A critical individual for the sales & marketing department.  Prospective tenants need to be able to see pictures, right?

  4. Network (as a team member): We always see our network is always a team member.   Whether it is a simple phone call or via social media, the network always seems to help us in one way or another. 

Remember, it’s WHO

Although we may have our checklists, it really is about who we hire, not what we hire (or even how we can tell them to do their role).  We’ve found this is the best way to achieve our goals.

Sometimes it’s best to put it in a metaphor: “We want everyone rowing to the same cadence in the same direction.”  At CF Capital we strive for excellence.  Naturally, we want to team up with the best out there… the “best in class.” When we find smart, committed people, we ask them to tell us “how” to best accomplish our goals, and we get out of the way so they can bring us there.

We typically look for thoughtful people who default towards taking initiative, and individuals with a temperament that aligns with ours, but have complementary interests or abilities.  Because after all, we will be spending long, sometimes challenging hours “in the trenches” together at some point.  Lastly, we seek out a little bit of dreamer in our partners to bring an ambitious craft to the table. Ambition is the core to our firm’s identity, and to align with us you’ve got to have big dreams for yourself as well, and simultaneously be humble enough to work towards creating something much larger than yourself. 

Closing Thoughts

The combination of art and science in tailoring, structuring, and executing on the team building front is entirely dependent on the needs and goals of a real estate investment operation (or business).  Despite the case by case adjustments, at CF Capital, we are relentless in putting together an unified team effort to achieve greatness.

Assemble-the-Dream-Team-Pic-1.jpg

“If everyone is moving forward together, then success takes care of itself.” - Henry Ford

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Return IRRegularities: Let’s Talk About Internal Rate of Return…

"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." -Ben Graham

“I see all these return metrics on your presentation. There’s ERM… there’s CoC… there’s AAR… and there’s this IRR metric.  Can you give me a refresher?  What do all of these return metrics mean, again?”  One of our potential partners asked me this the other day.   

Let me first say that we are extremely thankful for our engaged audience.  As you may have noticed, many of our recent posts were inspired by the incredible dialogues we have with “our tribe.”  This is not intentional, but we do want to cover topics that matter on top of the topics that WE THINK matter.

We believe it is absolutely critical for our audience to understand the fundamental building blocks of real estate investing in order to fully comprehend areas of greater complexity.  With our blog, we aim to cover it all.  This blog series is YOUR RESOURCE.

Going back to the question.  After thinking about it, we thought it would be helpful to provide our audience with insightful details on the return metrics we use in real estate.  After the “essentials” are covered, we will dive deeper into one of those metrics.  

The first in a series of blog posts related to investment performance measurement is internal rate of return, also known as IRR.

So let’s get started with the broader overview.

The “Essentials”

There are quite a few performance metrics in the investment industry, but to keep things simple, we will cover the ones that we believe to be the most common in our multifamily investment universe:

Average Annual Return (“AAR”)

  • Definition & Calculation: AAR is the average amount that is earned each year over a given period of time. To calculate AAR, you take the sum of the return rates of your investment over a specific number of years and divide it by the number of years.  In our case, this number would almost always be shown in our presentations as net of fees.

  • Application:  AAR is just another metric used by investors to look at the overall historical performance of a property investment, which is often used as a relative benchmark for the current or future (i.e. projected) AAR.  AAR  is most frequently measured over the life of the investment, but it is also common to measure over three-, five-, or seven-year periods.  

This metric is helpful if an investor wants to know the potential investment's current annual return as compared to its historical return.

Some say that an attractive AAR is somewhere in the range of high teens to 20%+.  This varies in our industry based on the amount of risk you are willing to take in a property investment.

It is important to remember that average annual return is not the same as average annual rate of return (i.e. annualized returns or the geometric mean of returns) -- this is an entirely different metric from AAR that factors in compounding.

Cash-on-Cash Return (“CoC”)

  • Definition & Calculation (CF Capital’s common use case for CoC): The metric is calculated using a formula that divides the property's annual net cash flow, after paying debt service, by the initial investment amount, and it is shown as percentage.

  • Application: CoC is one of the simplest approaches for measuring a real estate investment's performance.   This metric can be split up over specific periods of the lifetime of the investment, but it is almost always used to reveal the performance over the life of the investment (i.e. entry to exit).  

We should note that CoC as a return metric doesn't take into account the time value of money.  In other words, when looking at the investment performance of two properties with the same CoC, there is no consideration for which property was sold first.  The metric also doesn’t include the property’s appreciation (only after the property is sold). 

Some say a good cash-on-cash return for our investment universe is 7-10% over the lifecycle of the hold period.  But really it is subjective and depends entirely on the amount of risk taken.

Equity Return Multiple (“ERM”)

  • Definition & Calculation: The equity multiple on an investment is a metric that measures the total cash return over the entire lifespan of the investment.  The formula is the amount at exit (i.e. total amount given back → distributions + total cash back at sale) divided by the amount at entry (i.e. initial investment amount).  Note that this takes into account any fee deductions involved with the investment.

  • Application: You might also see ERM referred to as Multiple on Equity (“MOE”), Multiple on Invested Capital (“MOIC”), and Return on Equity (“ROE”).  ERM can be shown as unlevered or levered, but in our case, we will always show ERM on a levered basis because our investments benefit in many ways by properly leveraging some sort of debt financing to amplify our returns. 

One simple and easy way to think about ERM is to look at it as how many times you get your capital back on an investment.  Many operators target an  ERM of 2x, but this also is subjective and depends on the idiosyncratic risk taken.

As with the CoC return, the ERM’s drawback as a performance metric is the fact that there is no consideration for the time value of money.  The multiple only shows how many times you multiplied your initial investment amount.  This also means that the metric can easily be skewed if there were many cash inflows and outflows over the investment period (we can dig into this in a future post).

Internal Rate of Return (“IRR”)

  • Definition & Calculation:  IRR is the rate (%) earned on each dollar invested for each period of time that it's invested.  Some simply call this interest.  But you may alternatively perceive IRR as the rate needed to convert the sum of all future cash flow to equal your initial investment.  It sounds confusing, but it is nothing an excel spreadsheet can’t handle, we promise.  The formula is shown as follows (setting the NPV to zero and solving for the discount rate, which is the IRR):

(Note that the IRR presented to our investors deducts any fees related to the investment.)

  • Application: IRR is a popular way to measure investment performance in real estate.  IRR considers the time it took an investor to get back an initial investment and any of the investment profits.   

Unlike the other metrics, the timing of when cash flow is received has a significant and direct impact on the calculated return (thus, it is dollar-weighted [aka money-weighted], taking into account time value of money).  In other words, the sooner you receive cash back, the higher the IRR will be.

A “good” IRR often is considered to have a range similar to AAR (unintentionally); high teens to 20%+.  But just like the other metrics, it is subjective and is dependent on risk.  It is also dependent on so many uncertainties and when invested capital is actually returned to investors.

It is worth noting that IRR doesn't always equal the annual compound rate of return on an initial investment.  An internal investment can increase or decrease over the life of the investment, and IRR does not account for what happens to capital that is taken out of the investment.  Another flaw with IRR relates to the formula potentially producing negative returns in between the time of the initial investment period and the time of the sale, causing multiple results for IRR.  This disruptive issue of negative IRR happens when the aggregate amount of cash flows caused by an investment is less than the amount of the initial investment.

The main thing our audience needs to remember is that no single measure is all-encapsulating and does not cover everything needed to assess a real estate investment.  Multiple measures are needed to determine the performance of an investment.  

A Deeper Dive Into IRR

Broadly speaking, the internal rate of return (“IRR”) is a metric used to estimate the profitability of investment by calculating the rate of return on each dollar invested for the time period when it was invested.

IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.  IRR calculations rely on the same formula as NPV does, but it is not the actual dollar value of the project.  It is the annual return that makes the NPV equal to zero.

Here are the items you “need to know” organized in bullet points:

  • General Use Case → To measure attractiveness of an investment.

  • General Rule for Judgment → The higher the IRR, the better.

  • Exception to the Rule → If cash flows back to the investor (i.e. inflows), including sale proceeds are early/quick, and the total return is not significant (e.g. ERM) .

  • Information Need to Calculate → Initial investment amount, size and timing of cash flows (including the cash proceeds from the sale, if there was a sale).

  • Advantages and Weighting of Return → Appropriate for those looking to measure performance of cash flows and the speed of the growth of the investment value.  As a metric, IRR would be very helpful to use for budgeting, especially over longer periods of time.  IRR is a Dollar- or money-weighted rate of return.

  • Limitations → Calculation is not as simple as other metrics and could result in multiple IRR values; IRR values are difficult to predict; 

What else might be important to know?

As mentioned above, generally, the higher the IRR the better.  Also, the IRR metric is a good way to compare the real estate investment in focus with benchmarks, such as other opportunities in the marketplace, or historical IRR’s for the respective investment universe. However, if the real estate investment resulted in realized profits very early and the IRR is skewed high, the total amount given back may or may not have been significant.  One can find this out by calculating the ERM, which is explained above.

We realize that the formula and calculation process seem daunting, but we would be happy to walk you through it or provide you with a template to get a better, hands-on understanding.

Essentially what you need to know to calculate IRR is: 1) set NPV equal to zero and solve for the discount rate (i.e. the IRR); 2) The initial investment will always be negative because it shows an outflow occurred (i.e. an outflow to be invested in the real estate); 3) after the initial investment, each cash flow could be positive (an inflow) or negative (an outflow); 4) because of the nature of the formula, you must solve by trial and error or use software to do so (i.e. Microsoft Excel)

What’s the difference between compounded annual growth rate (“CAGR”) and IRR?

  • CAGR typically uses only a beginning and ending value to provide an estimated annual rate of return, IRR uses values in between the beginning and end, including the cash flows.

  • CAGR is a simple calculation while IRR is more dynamic.

Also, what’s the difference between return on investment (“ROI”) and IRR?

  • ROI measures total growth of an investment from start to finish in percentage terms (ERM in multiple terms), while IRR measures annual rate of return.

  • ROI is a simple calculation, involving the beginning and end value of the investment, but is not always as helpful for longer time periods and factoring in periodic cash flows and returns.

It is important for you to know the difference between IRR, and all the metrics mentioned above -- AAR, CoC, ERM, ROI, and,, CAGR.  (We know… there are a lot of acronyms being “thrown around.”)  By knowing the differences, you can tell when it is appropriate to use IRR as a return metric and you will be armed with the ability to properly analyze investment opportunities based on the projected return metrics.

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Financing Secrets: Let’s Talk About Selecting the Proper Debt for an Asset…

For those looking to understand our financing process a bit more, and for those of you who have not read our e-book, we thought it might be helpful to talk through debt selection.  That is, the how and why that goes into selecting a certain type of debt to complete the financing of a multifamily real estate deal.  

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First, we determine how the property is operating in the current marketplace by reviewing the property financials.  We work to identify potential upside through either physical reposition of the property and/or operational upside.  From there we formulate a business plan that our team could potentially implement over the projected hold period of the property.  A key piece of our business plan includes asking ourselves, “What are our debt options?” and ensuring that we marry the appropriate financing to the business plan and opportunity.  Different business plans and objectives will require different types of flexibility and exit options.

Two Types of Debt: Categorized by Set of Lenders

In our case, we would be working with two different options for loans: GSE (Government-Sponsored Enterprise) and non-GSE.

GSE - A Government-Sponsored Enterprise, often referred to as an agency, in this context is what we know as Fannie Mae or Freddie Mac.  For simplicity, these are the houses that would provide us a permanent loan that often has a fixed rate over a specific period of time.  They also offer adjustable or floating rate loans, sometimes with flexible terms like an interest-only period.
Non-GSE - These can be life insurance firms, CMBS lender, regional or national banks, as well as alternative lenders (i.e. non-bank, third-party loan providers).  Life insurance firms and CMBS options are typically longer terms and require more stringent terms than a loan originated under one of the above agency programs.  These types of loan options will typically require lower leverage and longer lock out periods and/or larger prepayment penalties in return for attractive rates.  

Alternatively, bridge financing options are short-term loans that “bridge a gap” while you reposition a property and wait for a permanent loan to become more achievable after a property has been stabilized (see below).  Bridge financing would be leveraged by CF Capital to bridge the gap between the acquisition and reposition of a property allowing for a great deal of flexibility on when to sell or refinance.  In most cases bridge loans typically have higher interest rates than GSE options, are interest only payments, and are for shorter terms ranging from 18 months to three years, often with an option to extend for one to two more years. 

So what factors determine if we should choose a GSE loan or non-GSE loan?  

Determining the Property Type

Within our investment criteria , there are two property types within multifamily real estate we could potentially look at: Stabilized and Distressed.  One could take a guess what these types mean, in general, but when it comes to the more technical definition we must look at specific factors that might make a property categorized as stabilized or categorized as distressed.

The most important factors are occupancy and the amount of value-add (which can be operational and/or physical value-add).  

To fit in the stabilized category, a property would need to have occupancy levels that are greater than 90% and needs a relatively low amount of value-add.

A property in the distressed category would be the exact opposite: less than 90% occupancy and/or a relatively high amount of value-add. 

Why does the property type matter when choosing debt? Let’s talk through why.

Tying it Together: Debt Options According to Property Type

By identifying the occupancy and value-add factors, we are now on the right path in figuring out who to go to for a loan and what type of loan that is most appropriate for our investment.

Stabilized

Typically, a stabilized property would put us in a good position to work with a GSE lender for a permanent loan that might have fixed or floating interest rate terms.  

Among the various market conditions that would allow us to determine the type of interest rate terms, one important area to look at is where the market rates are at the time of the loan relative to historical averages.  If they are significantly lower, a fixed rate might be preferable.  

An interest-only period in this loan might be an option, but it is not always a guaranteed part of the equation.

To receive a loan from GSE lenders, our property we need to meet the targets required by the GSE lender -- loan-to-value (“LTV”) and a debt-to-service-coverage (“DSCR”) of at least 1.25.  Meeting these metrics and others, will tell us if we are in a position to be approved for a permanent GSE loan.  

At CF Capital, we like to take things one step further and optimize these targets so that we are not over- or under-leveraging, as well as considering a more attractive break even point.  

We would like to think that this reveals our partnership mentality with our investors.  If we are cognizant of cash-on-cash returns by optimizing the key loan metrics, we believe we are best serving our investment partners.

Distressed

Back to our comment about the ability to choose the type of loan or not -- if the property does not meet the requirements by a GSE, then we may have no choice but to go the non-GSE loan route.  

In the case of a distressed property, we would approach alternative lenders as well as local and regional banks to (typically) provide us with bridge financing.  The lenders here understand that there is a need for a more significant transition, but may charge a higher interest rate in the short-term and require some sort of collateral.  Often, these are loans with an interest-only period and may or may not have fixed or floating interest rates.

The goal with bridge debt from a non-GSE lender is to use this short-term temporary financing and switch to a permanent loan.  That is, if the situation permits.

Main Takeaways

  1. A stabilized property would typically require 90%+ occupancy and less value-add.  In this case we would be more inclined to go with the GSE lender for a permanent loan, but we must factor LTV and DSCR into our decision-making.  We also must be cognizant of cash-on-cash return metrics, as well as the risk factors of leverage and market conditions. 

  2. A distressed property would typically have less than 90% occupancy and significant value-add.  In this case, we would most likely go with a non-GSE lender to provide bridge debt as a means to transition to a permanent form of debt.  Interest-only provisions are more common here. 

It is worth noting that each property is unique and specific, so choosing the form of debt should be treated as such.  By partnering with the best lenders and brokers in the business, we should set ourselves up nicely for long-term success.  But, ultimately, we (as the investors ) make the final decision.

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RULE #1 - Don’t Lose Money: Let’s Talk About Evaluating and Minimizing Risk…

“Successful investment is about managing risk, not avoiding it.” - Benjamin Graham

Recently, I've found myself talking about risk with a lot of people.

Most of it is because of our previous articles -- Navigating the Market Cycles, Due Diligence, and Underwriting Bad Debt, just to name a few.  People believe that investing in real estate is much riskier than investing in the stock market.

These discussions triggered an immediate reflection on how we evaluate and manage risk in our property investments.

There's a lot you can do to reduce the chance, it turns out.

First Things First: Put the Property in an LLC (see our post about syndications)

Having rental properties exposes us to the risk of being sued, just like any other company.

The trick is to keep our property investments apart from one another and from our personal finances (i.e. the CF Capital team, our co-sponsors, our property managers, and most importantly, our investors).  You accomplish this by forming a separate LLC for each property (or in a series LLC).  Then you treat each LLC as if it were its own business. EIN numbers are assigned to each of you separately. 

You'll get your own bank accounts.

Is it a decent amount of effort on our end? Yes, but it is more than necessary to protect ourselves and our investors legally.

More Legal Protection: Get the Proper Insurance (get in touch with us about our e-book covering more of this topic)

While the LLC provides some security, you should still have adequate insurance coverage.

Not only should you have adequate coverage for the property, but you should also be covered by umbrella insurance to cover something that the property insurance doesn't cover.

Downside Protection: Buy the Properties that People Live in During a Recession (see our post on Navigating the Market Cycle)

We don't typically seek to purchase "A" assets as a part of our core acquisition criteria.

What does it mean to have a class A property?  Picture a glass-enclosed modern apartment building with a dog park or pool, or a charming Tudor house with a backyard in a neighborhood.  These are the apartments that rent for $2,000 or more a month.  

These aren't our rentals.

We purchase properties in the “B” and “C” range.  What is the reason for this?

Consider what will happen if an individual who is living beyond their means in a "A" property loses their job during the next economic downturn.

What happens to that person?  They'll be relocating to our B or C rated property.

Similarly, if the economy improves and everyone has a job, people in the D and C classes move up to the B class.

The sweet spot for rentals, we assume, is somewhere in the center.  You'll be able to profit from an upswing while still weathering a storm during a downturn.

Protection We Can Manage: Cover Our Bases in Our Due Diligence, Underwriting, and Business Plan (see our posts on Due Diligence, Underwriting Bad Debt, Cap Rates, Rent Growth, and Vacancy, as well as our Business Plan)

When it comes to research, underwriting, and crafting our business plan, it is all about the grunt work -- we are not afraid of the tremendous amount of work it takes to be thorough and thoughtful.  

We wouldn’t be able to sleep at night knowing our investors’ (and our own) capital is at risk because we took a shortcut.

Formally, it is our fiduciary duty to be excellent stewards of capital.  How we see it, the only way to do that is for us to do everything we can to protect our investors’ money with our “blood, sweat, and tears” (particularly, deep research, thorough and conservative underwriting, as well as thoughtful creation of our business plan).

Actions, Not Just Words: Execute in Asset Management (see our post on Asset Management)

Building off the previous section above, let’s make things simple here: if you put your investors, the community, and the residents' interests above all else, you maximize your chances of success.

Having PURPOSE for what we are doing makes things so much better; probably one of the main reasons it is one of our core values.  Not only is it a driver, but this (perhaps counterintuitive) approach actually puts us in a better position to “win.”

The funny thing about this world is that “the more you give, the more you receive.”  And this is speaking in terms of receiving both tangible and intangible benefits.

That is why we choose to do everything humanly possible to make sure every party is pleased with the outcome.  

In the area of asset management, WE EXECUTE.

Asset Repositioning: The Little Things Count (see our previous post)

Vacancies tend to rise during a downturn, and housing options expand dramatically.

So, how can you make sure your apartment complex isn't one of those that sits empty during a downturn?  Aim to make it the “nicest property on the block.”

The benefit of making your property the nicest on the block is that you can charge premium rentals during good economic times.

I'm not suggesting you go overboard with stainless steel appliances and granite countertops. However, a little maintenance and slightly higher finishes than the group average are a perfect way to reduce danger in the long run.  

CF Capital’s value-add strategy focuses on the “numbers” in our models as well as our cost-benefit analysis to determine the appropriate measures to take in order to reposition our asset, the property.

In essence, when you have a desirable property that is in high demand, your risk goes down.

The Bottom Line: Cash Flow, Cash Flow, Cash Flow (again, read more about this in our e-book)

Be sure to “buy it right” when purchasing investment properties.

What exactly does this imply? It means that you have pre-defined requirements for buying a property and only buy properties that meet those criteria.  Never, ever compromise.

The cash flow generated by a property is one of the most important criteria.

We like to use a cash-on-cash return threshold of 7%, as stated in previous articles.  We normally won't acquire an asset unless we can hit this minimum average threshold over the hold period.  Of course, there are exceptions to this law if a property has a significant amount of untapped secret value, for example.

You will reduce the risk by maintaining a certain minimum amount of cash flow.  And if rents fall marginally during the next downturn, you'll be able to bear the loss.

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