The Uncommon Path: Let’s Talk About Being a Contrarian….

“One must avoid snobbery and misanthropy. But one must also be unafraid to criticise those who reach for the lowest common denominator, and who sometimes succeed in finding it. This criticism would be effortless if there were no "people" waiting for just such an appeal. Any fool can lampoon a king or a bishop or a billionaire. A trifle more grit is required to face down a mob, or even a studio audience that has decided it knows what it wants and is entitled to get it. And the fact that kings and bishops and billionaires often have more say than most in forming appetites and emotions of the crowd is not irrelevant, either.”

― Christopher Hitchens, Letters to a Young Contrarian

By definition, a contrarian is someone who opposes or rejects popular opinion. We think, perhaps a better way to put it is: a contrarian mindset might not be about opposing the crowd, but to think for oneself. It’s not in what one thinks, it’s how one thinks.

We acknowledge and can directly relate to the notion that being a contrarian can be uncomfortable for some, while he or she is daring to be different. Figuratively speaking, it means standing away from the crowd, all alone at times.

With that said, we firmly believe that “comfort is the enemy of progress,” as P. T. Barnum once said.

Do you think that you would see any of the incredible advancements in technology today if everyone stuck with the status quo and agreed with the popular thought at the time?

Contrary to one’s immediate belief, in being a contrarian, you open up a wide range of possibilities and a better chance to capture incredible opportunities. A contrarian is not limited. A contrarian is freed from shackles of constrained thinking.

What are the factors that dissuade independent thought? Is there actually something to be said for the wisdom of crowds or is the explanation to be found in less “clever” attributes? Studies and insights from psychology, behavioural economics and other disciplines offer some useful clues as to why the herd is so large and, by extension, why contrarians can bring such value.

For example, at the core of recent research done in the field of psychology, is the contention that the human brain is innately lazy. Heuristics, the mental shortcuts we employ to form judgments, are one symptom of this weakness.

We are definitely (or at least we think we are) not individuals that are naturally lazy. In fact, I don’t think our brains will let us.

At CF Capital, we are always thinking about how we can do things better. We constantly remind ourselves to be skeptical of any “fact” that becomes conventional wisdom. By necessity, remarkable performance at a firm and investment level will always accrue to a minority; so by design, we try to seek out situations when dominant narratives are inaccurate. Kind of like uncool (but talented) kids that get picked last in school playgrounds.

But moving on from our rant about contrarian philosophy, you might ask, “how do you apply this to what you do as a firm?” For the sake of being concise, we have provided some examples in bullet-point form:

We seek out investment opportunities where most wouldn't dare to go. We do enjoy the thrill of finding the hidden gem and “love swinging at fat pitches”, but we do not let that overpower our primary mission.
We are careful, patient, and thorough. We let our depth and craft guide us to greater performance in both business and investing. Our out-of-the-box thinking is immediately evident in how we navigate the investment process, especially with the business plan.
We believe in transparency and the power of giving. From the ELEVATE podcast to this blog and other investor communications (see our post about investor communications), we are constantly thinking about how we can give back to our partners. We truly believe that “the secret to living is giving.”
We believe in the power of a cross-discipline approach. One immediate example of this is Tyler’s application of how both in real-life and in real estate investing, good habits, a positive mentality, and an attitude of constant improvement/growth can lead to exceptional results.

As some of you can relate to previous experiences, these (above) are not characteristics widely found in both the broad and real estate investment world. But to paraphrase the beginning portion of this discussion, “we find comfort in being different.”

As we mature as a team, we are happy to continue to forge our own path, even if this path is often lonelier. Over the long run, we cannot simply follow that which is popular, and expect to do something exceptional as a firm. We are enormously grateful to our partners and audience for their trust in us, the “contrarian guys.”

“Push your boundaries beyond the ordinary; be that “extra” in “extraordinary.”

― Roy T. Bennett, The Light in the Heart

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You’d Depreciate It: Let’s Talk About Tax Rates....

“The hardest thing in the world to understand is the income tax.” - Albert Einstein

Tax rates... probably seems like the least interesting topic to read about. But we will do our best to make our discussion as concise and as interesting as possible.

First, before we begin, let's establish that in real estate investing, tax is (almost always) our largest expense.

So what do we do to reduce such a significant expense? We like to approach everything with thoughtful insight, and build a strategy around the varying tax codes in different markets.

Basically, our goal is to have a deep understanding of the geographical differences and approaching tax as something unique for every single market.

Some real estate investment firms are comfortable with only a basic level of comfort with each submarket’s tax laws. We believe that such groups are doing their investors a disservice and are not being prudent stewards of their investor’s capital.

CF Capital applies a different attitude and a more sophisticated approach.

So where do we begin? Initially, we craft a process that would help us identify tax rates and assessed values. Because we look at deals in multiple markets, we make sure we partner with and lean on best-in-class real estate attorneys who help to provide guidance in this area. We also gain clarity through the industry experts in our target submarkets.

Although we all have our (somewhat impatient) moments, we remind ourselves it is a process. And that process does take time.

After all, property taxes can make or break a deal.

As we navigate different states, counties, and submarkets we are attentive to how each governing body has set their laws for taxation. At every level there is a wide variety of different mechanisms for how taxes are calculated, such as how the area counts millage rates.

In Ohio, the deals we evaluate can be very subjective, which requires us to dig into everything a bit deeper. Whereas in Kentucky, it is really just about the millage rates, with some caveats depending on individual counties.

After we gain an understanding of a market, we run scenarios through our models in order to maximize efficiency from the tax expense standpoint.

We take into account the types of business expense deductions that might reduce our tax base. Among these deductions might be the cost of insurance or cost of maintenance.

Also, we factor in the impacts of our value-add strategy. Capex, or the large improvement/renovation expenses, can significantly alter how much we pay in taxes. To benefit from capex, we can do things like front-load depreciation or capture tax credits.

We want to make sure that you are not getting the wrong impression here. Yes, we want to reduce our tax expense. But we are not trying to do everything in our power to avoid paying our fair share. Instead we are looking to figure out what we can do to keep taxes in line with expectations so that we are contributing to the communities in which we invest. After all, as some of you may know, our tagline is, “Elevating communities together.”

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The Little Things Count: Let’s Talk About Asset Repositioning…

A few of our readers have been asking us about more details of our value-add program. More specifically, “How is CF Capital making targeted improvements to a property?”

We could (and would love to) give you a long detailed response, but essentially we do this through our asset repositioning process. Asset Repositioning is the strategic use of improvements implemented at our properties in an effort to improve their position within the marketplace.

The overall purpose of an asset reposition is to ultimately improve the asset so that there are improvements in the financial performance of the asset. If you take good care of an asset and are diligent in your application of these principals, it will be rewarded in cash flow and asset value among other areas.

Of course we must have a vision for the asset, but we cannot stress enough how important it is to back up that vision with data and a real rationale.

“By failing to prepare, you are preparing to fail.” - Benjamin Franklin

In our post about due diligence, we discuss our process in how we gather all information after the initial underwriting process. That is, any information from a comparable standpoint and a market standpoint so that we can further understand what we are missing. An example of a goal is answering the question, “What can we do to bring an asset from a class C to a class B property, and is it in demand in the marketplace?”

We also discuss this further in our post about CF Capital business plans.

Along with asset management, asset repositioning is one of the key components in the execution of our business plan. Essentially, we are bringing the business plan to life.

So what are some examples of repositioning?

Aesthetic, Cosmetic, and Building Performance Improvements

Any improvements made to the interior and exterior of the asset are considered to be a part of repositioning. With the interior, it could be adding granite countertops, installing new wood flooring, connecting recessed lighting, or any of the features that might be attractive to the tenant marketplace.

With regard to the exterior, it could be something as simple as painting the exterior of the buildings. It could also include improvements to common areas such as an updated clubhouse or fitness facility, an addition of outdoor lighting, and an improvement to the property’s landscaping.

Additionally, we make an effort to add value by implementing energy-efficient improvements such as low-flow toilets and shower heads, LED lighting, and potentially new windows. Some tenants are attracted to this feature not only for its environmental benefits, but for the savings they are able to realize on their utility bill.

Our post about capex also discusses asset improvements in further detail.

Property Element Repurposing

Repurposing is just one of the many opportunities where we are able to be creative. In this case, a sizable extra maintenance shed could be turned into an extra workplace or a small clubhouse for tenants. Or a common area could be repurposed to be a lobby with mailroom and concierge service attendants.

When repurposing, it is also important for us to keep our asset’s location and target tenant in mind. For example, if our asset is located near an area that contains many technology companies, outfitting an apartment complex with high speed technologies and amenities can attract the people who work at these companies. Another example is if our asset is in the suburbs, implementing family-friendly features such as playgrounds or extra parking spaces can go a long way.

Operations, Property Management, Branding and Marketing

As it relates to operations, property management, and personnel, the goal in repositioning an asset is to provide an improved community for our tenants. Having maintenance personnel on-site and/or on-call 24 hours a day is one example of this. This could also mean having specific amenities on the property that attract the ideal tenant.

In branding and marketing, we may want to want to update the external world’s view of our property in a light that more closely aligns with our updated property. Examples of this could be re-naming of the asset and/or changing the aesthetic of the branding.

The list is seemingly endless.

***

The planning process of our value-add is more or less the asset repositioning portion in our business plan. Without repositioning there would be no value-add program.

The bottom line is that any asset can be repositioned and improved. As operators, it is necessary to back up the decisions by answering “is this in demand?” or “is there a gap that is being presented?” It all starts with the research and becoming well-informed. From there it is about understanding and bringing all of that to life through sound execution.

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Long-Term Leadership: Let’s Talk About Investor Communications…

At CF Capital, we are committed to being transparent with our partners. Over the past months, we have increased our efforts to make sure that our audience gets to know us not only as investors, but as people. Just as a review, here are some of the topics we have covered in our blog:

We plan to continue educating our investors for the foreseeable future and fully intend to be as communicative as possible.

Although cliché, we think the following quote by the Dalai Lama is the belief we carry when it comes to transparency:

“A lack of transparency results in distrust and a deep sense of insecurity.”

We believe the foundation of a good relationship is communication, so that there is mutual trust and security for a flourishing partnership. The line of communication creates an opening for investors to let us know their expectations and for us to let them know our expectations.

As stated above, we will continue to educate, but we also want to let our investors know that we are being good stewards of their capital.

What does that mean? We believe that good stewards are ethical, operate with integrity, and treat other’s interests and capital ahead of their own. Good stewards also protect their investor’s capital and refuse to go to sleep at night without a sense that they are doing everything they can to do best by their investment partners. Part of this is placing hyper focus on efforts that ensure the investment is as successful as possible.

Nevertheless, we will not take your vote of confidence in us for granted!

Our communications are initiated with the idea that investors are entitled to be fully educated on the status of their investment capital and the assets they are invested in. This means providing detailed ongoing color on how we are handling challenges and/or opportunities. We believe this is extremely important.

The “Golden Rule” provides a poignant guiding light for us in how we approach investor communications and relations in general: Do to others what you want them to do to you.

CF Capital provides comprehensive monthly updates to all investors. We also provide more in-depth communications on a quarterly basis, including financial performance, updates on capital expenditures, submarket pertinent data, and general asset management key performance indicators. Additionally, we like to host an annual meeting with our investors to give updates on current status, what we're dealing with, and what our intentions are moving forward to accelerate the partnership’s interests and march forward to further asset optimization.

Any thoughts on the macro and micro economic environment and the marketplace will also be shared in our communications. This means a transparent dialogue on leasing, expenses, market occupancy, and any other relevant metric.

On an individual property level we will always share the financials, disclosing the key performance indicators, such as vacancy, rent growth, or capex.

For example, in one of our communications we might talk about our expectations of replacing the roofs at an apartment complex. “We initially projected that we would have to replace every roof in the complex, but instead, only needed to replace three out of the ten roofs.” We are always certain to provide clarity on thought processes and supporting evidence towards decisions made in the best interest of our investors. We lean on our team of experts in making decisions such as this example, and are always certain to go the extra mile in making it clear why any decision has been made or adjusted.

Another example is just providing a general idea of the value-add program in our business plan and how it is playing out. “We planned to invest $7,500 in renovating units and raise rents by $150 to ensure our interior capital expenditure cash on cash is logical and in line with opportunity costs. We are happy to report that we have hit that target metric.” Furthermore, we always find it important to provide specific supporting data to keep our investors fully aware of the exact reality of the performance.

It is our commitment to provide complete transparency for the duration of our investments. Even in the event that an asset's particular performance has not met expectations for any reason. While rare, due to the painstaking detailed measures we take to ensure our research and execution plans are realistic and conservative, there are certainly times where unforeseen events occur that negatively impact performance.

Perhaps, in reference to the previous example, we have only been able to raise rents to $130. In this case we would provide information on why we anticipate this to change, if realistic, what we are doing to control what’s within our control to ensure the protection and growth of investor capital, and a timely evaluation of the conditions of the marketplace that leads us to make certain decisions moving forward.

It is in our core philosophy to never overpromise, but always strive to overdeliver. We want people to know that we truly care about them, and that we have our finger on our pulse, our hands on the wheel, and our eyes on the road. Our team is committed to open, honest, and timely communication with our partners, in good times and, especially, in those that present unforeseen challenges.

We are always available if you have further questions or would like to discuss something with us on a one-on-one basis and keep this availability for an expanded discussion beyond our standard communication process. This open door policy is how we expect to be treated when we participate with other sponsors, and we believe deeply in this commitment to our investors.

Thank you all again for engaging in this blog and we hope it is valuable for you -- we are extremely grateful to have the opportunity to share our thoughts with everyone and will continue to strive for adding continued value to you through this education platform and through presenting attractive investment opportunities.

Don’t hesitate to reach out to us by scheduling a meeting to discuss your goals and how CF Capital can be a part of your investment strategy.

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Work Over Time: Let’s Talk About Asset Management…

“The role of the musician is to go from concept to full execution. Put another way, it's to go from understanding the content of something to really learning how to communicate it and make sure it's well-received and lives in somebody else.” This quote by the famous musician, Yo-Yo Ma, resonates deeply with our team at CF Capital.

Though we do not think of ourselves as musicians nor are we particularly adept at creating original music, we do believe Yo-Yo Ma makes a point that is applicable to aspects of what we do everyday with CF Capital.

Over the past weeks we have been speaking to many parts of our philosophy and process. We discussed how we go from an idea to planning. And how we go from planning to execution. Although we believe our investment process is extremely important to setting the stage for a successful investment, ultimately none of it matters if we do not execute.

“Having a vision for what you want is not enough. Vision without execution is hallucination.” -Thomas A. Edison

Today we will discuss asset management, or what we would like to think of as the methods of execution. What do we mean by this? Simply stated, it is putting our business plan to action to deliver results for our investors, the community, and our residents.

At a fundamental level, outstanding asset management is effective management and leadership of our property management team. Asset management is also about communicating to help property managers make excellent decisions, while holding them accountable in an effort for all invested parties to achieve their goals.

At the end of the day, our goal has two explicit parts: 1) to protect investor capital; and 2) raising the value of the project, whether it is physically and/or operationally.

In order to achieve those goals we must “see things through” with a highly detailed lense with our property management team that is on the ground, taking care of the day-to-day with the property. Our business plan is our guide for asset management. Inside our ordinary expectations, we execute based on our business plan.

However, if we have learned anything from real estate and in life, it is rare to have exact circumstances occur as planned. Therefore, asset management isn’t just about managing the ordinary, it is also about recognizing problems and course-correcting when necessary. Execution can only be successful if we manage the unforeseen things that occur within our communities, in addition to ensuring the collaborative team effort to accomplish our stated objectives.

We always “expect the unexpected,” and are ready to adapt when we are faced with a challenge. This mindset serves us well as it prepares us for resiliency and ultimate success.

The CF Capital team does everything to ensure that we are holding our own team accountable, acting as leaders, while focusing on the performance metrics in a detailed capacity. The metrics reveal the effectiveness of our methods and show if we are gaining traction with income and expenses -- whether it is leasing or managing expenses or other income. We track key performance indicators, or KPIs, closely to ensure our efforts are ultimately being realized as results as expected in our business plan.

Another key part of asset management is implementing the capital expenditure plan as formulated in our business plan.

If we planned to make programmatic improvements to plumbing, for example, our team must coordinate with our property management company, subcontractors in the market, and the maintenance staff to ensure the successful implementation of this investment. We also must make sure that the plumbing installation project goes as smoothly as possible with minimal cost and time overruns, and minimizing resident disruption. If a problem comes up, we must provide guidance in the best way to solve the problem and further give our team the tools to make the best time sensitive decisions where appropriate.

For the sake of simplicity, we want our readers to take away that asset management may seem quite simple, but there are many variables that come into play. Our team is dedicated to being detailed, diligent and focused to execute in the long run through asset management. We believe this persistence offers peace of mind to our investors, employees, and residents of the communities in which we invest.

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Just Nailed It: Let’s Talk About Capital Expenditures…

Last week, after we posted our article on the business plan, another reader reached out to us over email:

“Hey guys -- I love the idea of how you go about formulating your property specific business plan. I know that capital expenditures must be a big part of this plan, but what is your process for choosing and handling the specific improvements? It seems to me that choosing the right capital expenditures has a lot to do with the cash flow and value of a property. Could you shed a little light on how CF Capital approaches this portion of the business plan?”

It would be easy to refer this reader to some of the popular books and articles talking about Capital Expenditure -- CapEx -- but since our process is different and ties to our unique business plan, it is worth discussing this topic with all of our readers. So thank you for your email!

As a quick review CapEx is money used for improvements in a property beyond normal repairs or maintenance.

On the finance side, it is treated as an investment in assets that can have an impact on cash flow and the overall value of a property. In a separate article we can discuss how we handle CapEx with depreciation/amortization and its impacts on tax, but today we will stick to our approach.

In our previous article about our business plan, we discussed how we arrive at a point that allows us to picture what it is going to take to get the property where we want it to be. That means what income and expense changes can be made to raise the cash flow and NOI, thus increasing the value of the property.

The business plan lays the groundwork for us to be able to visualize our path from “acquisition to exit.”

By implementing our CapEx projects we can make the necessary improvements needed to properly reposition the property. From this point, it’s all about getting granular.

Does the property need a new roofing? Does the property need new windows? A common misconception is that making improvements in those two specific areas will automatically increase the value of the property. This is not totally true.

But if it is not true, then why would we dedicate any money to these areas? Here it is more about protecting the property and giving it longevity so that other costs in areas like maintenance do not get out of control. In other words, they’re a necessary investment, and expense.

Our approach in selecting “new roofing” or “new windows” comes down to a cost-benefit analysis. If we project that the benefits exceed the costs (immediate and long-term), we start collecting quotes and taking bids from professionals who can help us arrive at those numbers.

These contractors also provide insight about the “numbers” we are looking at now as well as in the future.

We follow the same process for areas like heating, cooling, electric, and plumbing. Similarly, we can make additions or improvements to amenities, parking lot enhancements, signage, etc. Capital expenditures can be invested across anything that goes towards the operation of the property itself.

The ultimate goal is to ensure that the asset is protected.

It also means that we can think about efficiency and the types of benefits we can receive by “going green.” We can qualify for green financing if we make a substantial amount of eco-friendly improvements to the property, thus lowering the interest rate on our loan.

Regardless of what we do in the CapEx area, we want to make sure it all relates back to the business plan and supports our investment thesis, while enabling us to go out, execute, and perform for our investors while providing quality product for our occupants.

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Action Control: Let’s Talk About Our Business Plan…

Last week we received an email from one of our loyal followers:

“I really enjoy all of your blog posts. They have been very informative, and I am fascinated by your firm’s philosophy and process, which is why I am reaching out to you guys. It appears that your business plan is one of the key components to your ‘secret sauce.’ What is the business plan? Could you tell us readers a bit more about it?”

These are the types of emails we love -- we are both grateful and appreciative. We are also happy that our audience is finding value in our transparency.

So today we will address our reader’s request. Let’s walk through examples of how we formulate CF Capital’s business plans.

At the basic level, a business plan is created for each acquisition opportunity in order for us to organize our thoughts and formulate how we will implement our value add strategy.

An exceptional business plan is a function of the hard work done in underwriting and due diligence. You can kind of think of it as “the cherry on top” of the investment process sundae. The business plan wouldn’t be any good without the necessary and rich base.

Our deep work allows us to see what is happening with current operations at the property. This enables us to identify where opportunities can be maximized and where there is room for improvement. We then think about the desired outcomes from an income perspective as well as an expense perspective.

From this point on is where we have the most fun (or at least we think it’s fun).

The next steps are all about how creative and prudent we can be in our approach to adding value. Ultimately, we are trying to find ways to increase our cash flow and maximize the returns for our investors.

Each property is different and is essentially it’s own independent business. Therefore, every business plan will be unique and different. Some properties may have more problems on the income side, which would mean constructing a plan to capture the benefits from increasing the property’s income. Other properties have major expense problems, which create an opportunity for us to add value in reducing certain expense areas.

In one property we might plan to reduce expenses by streamlining the plumbing, heating, and cooling. Additionally, we might be able to reduce maintenance costs by making improvements to the property (i.e. capital expenditures).

With that same property, we would also aim to add value on the income side by improving utilities as well as adding other fees, services, and different rental options.

What do we mean by this? By adding pet fees, clubhouse rental fees, appliance rental fees, gym membership fees, concierge services, laundry services, and cleaning services, our investment property will be able to increase its total income.

Introspection and thoughtfulness are essential to crafting a sound business plan. If we aren’t doing things like looking out at reference points in the marketplace, we won’t be able to tell that our business plan is relevant.

We take into account things like our competitor’s rent, rent comps, or other rental prices in the same submarket. Maybe a submarket suggests that a higher value type of property would be compensated from a higher rent perspective. Figuring out the appropriate rental price level and tenant demands is our objective.

We also think about the type of tenant base we want. Then we want to attract them.

“Get closer than ever to your customers. So close, in fact, that you tell them what they need well before they realize it themselves.” - Steve Jobs

To implement that Steve Jobs philosophy, we believe it takes deep research and thought into their wants, needs, and desires. If the ideal tenant enjoys amenities like laundry service, we have to figure out how much they enjoy it. Also, how much are they willing to pay for it?

With all that said, our business plan does factor in many variables. In each unique case, we take a creative approach to identify the income and expense opportunities, and create a plan to capture any monetary benefits from adding value in those specific areas.

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A Work in Process: Let’s Talk About Due Diligence…

This week we are switching things up and discussing what happens after we have an opportunity under contract. At CF Capital we consider due diligence to be of utmost importance, and how thorough we are in this stage of the process sets us up on our path to success prior to making an investment. This phase of the investment process is all about identifying, verifying, refining, and triple-checking the critical characteristics that make up a property.

Our philosophy is that the only way we can be successful in due diligence is if we create a repeatable process while remaining adaptable. We also believe that this requires a thorough approach.

What do we mean by thorough? The common latin phrase, “Nullius in verba,” means “take nobody’s word for it. We think this reflects our exact mentality when we approach due diligence.

“No research is ever quite complete. It is the glory of a good bit of work that it opens the way for something still better, and this repeatedly leads to its own eclipse.” - Mervin Gordon

We want to leverage our team and best-in-class partners to turn over every stone on our own. We do this because we want the true perspective of what we are getting ourselves into, and not automatically assume that every bit of information we have collected from the current ownership group is 100% accurate and up to date. In fact, it is very rare to find a property where everything matches up.

Ultimately, we want our method of due diligence to gain additional trust in ourselves and the numerous variables in an investment (or at least as much as we can). After all, we are fiduciaries for other people’s hard earned capital as well as the diligent directors of our own participating capital, and we want to be able to sleep at night knowing that we consistently put our best foot forward as an investment manager.

With that said, let’s dive into some of the nuances of our due diligence process.

At this point, we have received information from the seller, and make assumptions and decisions on the deal based on that information. We overlay this provided data on top of our market knowledge and have discussions with our best-in-class 3rd party providers like property management companies and service providers. Now we must verify.

Before we dig into the areas that we verify, we believe it is worth mentioning the importance of doing so. First, verification allows us to identify any problems. Second, it serves as a means to protect ourselves and any potential downside from a potential investment. Lastly, it enables us to capture any opportunities when we look to verify every bit of information.

With flexibility in the order of verifying information, we begin by collecting and referencing as many documents as possible -- financial, legal, and operational.

On the financial side, we verify capital improvements and capital expenditure. In order to protect ourselves, we also verify income and expenses. Typically, we look at the past 3 years, but will consider longer historical periods.

To gain further clarity on the finances, we examine delinquency reports, lease audits, security deposit audits, property tax bills, tax appeals, and historical utility usage to cross-reference with anything we have gathered already.

Payment history is also reviewed. No one wants to find out that a majority of the tenants are regularly late on payments!

Finally, on the financial side, we verify forward-looking income and expense projections. We do this through rent comp surveys, submarket reporting , and required third-party reports. All in all, our goal here is to make our own projections as precise as possible by validating our assumptions from operational and capital improvement standpoints.

With regard to the legal due diligence, our legal team reviews piles and piles of documents.

You might have a mental picture in your head of us working late into the night with our desk lamps, reading through the large stack of property files. Basically, we are doing just that.

With one property in a target market, we have verified any document from legal audits and service contracts to something as simple as the title. We also made sure zoning is appropriate, and made sure that there are no encumbrances to the property. In this case there were no encumbrances, but if there were, we would need to sort it out before closing.

We continue our document review when we go through operational due diligence. We dig into building plans, floor plans, phase-specific third party reports, and other market reports.

Operational review also takes things one step further: we do hands-on inspections and investigations. In the physical inspections, we walk through every unit onsite at the property with our property management team and look at heating, cooling, plumbing, electrical, roofs, and windows just to name a few parts of a long list.

Furthermore, we will seek out and identify any other property intangibles. Is the site easy to access? How visible is the property? How does the property present itself to future tenants? There are many things that could determine the outcome of a property investment.

We even do a higher level investigation of the staff and tenants to get a feel for the past and current status. A similar investigation is done with nearby properties.

Perhaps you can tell from our tendency to include the “little things” in our articles, but we believe our due diligence process is a direct reflection of our detail-orientation. From all of this, we hope that you were able to take away some of the main points. We want to identify and be fully aware of the risks and how we can mitigate them, as well as the opportunities and how we might capture them. We go through due diligence to solidify our business plan and nail our execution so that we are set up to outperform for our investors.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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