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

**“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.

CF Capital Participates in Kentucky CCIM Chapter’s Multifamily Panel

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

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

Video of the full discussion can be accessed here.

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

COVID-19 Update and Outlook

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

HOW HAVE THE RECENT EVENTS INFLUENCED OUR OUTLOOK?

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

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

WHERE DO WE GO FROM HERE?

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

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

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

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

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

IN CLOSING

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

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

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

In Partnership,

Tyler Chesser, CCIM
Bryan Flaherty, MBA
CF Capital

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

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

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