Fellow investors and syndicators,
What are some of the core KPIs that you look at for benchmarking whether or not you'll move forward with a deal? Could be things like...
Cash on Cash return
Price per unit
Total equity increase
Cap rate at resale
Would love your insights on which ones are most important and what numbers you use as a minimum for each before you would consider moving forward on a deal.
There is no single one important number for us. Cap Rate is very important, because that is what the industry focuses on. We look at cap rate exiting, not going in. If market cap is 7%, then we want to have our property stable at an 8.5-9% cap. IRR is extremely important. We look for an IRR that can get our investors 15-20% over a 5 year scenario. All other things you mentioned are very important as well as the market/sub-market we are in, demographics, vacancy rates, city/county governance, etc.
I suspect that is going to be a different answer for everyone, and a combination of several factors.
For us its more of a total picture rather than one factor, although I guess I do focus on some more than others. I am constantly trying to learn from those who have been through several RE Cycles (the more the better!), and one common thing I hear is that focusing on cash flow when buying will help you get through the downturns. If (when) things change, if the value of your property drops because cap rates have increased, as long as it continues to cash flow and your debt isn't coming due then who cares? Keep making money until things improve, and the value hopefully returns.
So when analyzing a deal, I really try to look at the cash flow, but I also look at how aggressive our underwriting has to be in order to hit those numbers. I've been to a few events where Ken McElroy was speaking, and at one of them he was going over how they analyzed a particular deal. He made the comment that when evaluating a deal, whether you're buying it or investing with someone else, the pro forma rents are the most important thing to look at. I put a ton of value on anything Ken says, so I always want to know how someone came up with their rents, how they compare to the comps, and whether they seem achievable.
As far as cap rates, I don't focus much on the going-in rate. If there is a clear value add to be done, and its being proven with a substantial number of units, or nearby properties are doing the same thing, then I'm fine with that. You will hear a lot of people say NEVER to buy on pro forma, and only buy on actuals. If you're buying in a competitive market, good luck with that. Even off market stuff is getting a large premium over what the actual numbers warrant. I'm mainly working in Dallas Ft. Worth, and I can tell you owners are getting an enormous amount of the upside right now, but there are still potential deals to be had.
Reversion cap rates are another story. We always want to use a higher rate than whats going on now since things are so overheated. As an example, a C class deal in DFW may sell for a 7.0 or less, but we'll use 7.75 or 8 for a 5 yr sale. That's just a guess anyway, but if the cash flow is good, I feel ok about it.
There are situations where we will put more emphasis on the value add potential than the cash flow. I'm a year into a deal that we bought purely on pro forma, and had to give the owner FAR more than he deserved in order to win it. It has not paid out anything to the investors yet, but will likely double their money at the 2 year mark. The risk in that one is I had to use only 5 yr recourse debt, which I do not like doing right now, but the reward warranted the risk for me. On just about any other deal we like to buy with 10-12 yr non-recourse fnma debt in order to have the flexibility to ride out a downturn as all the very experienced people are always telling me.
So all in all, I just evaluate the whole picture. If every factor has been pushed to the limit, I will not do the deal, or invest in it if its someone elses. If one or two factors are aggressive, its a good (or great) area, and I trust the sponsor if making a passive investment, I'm ok with that.
Updated over 3 years ago
Sorry, meant to add a few other factors that we absolutely DO put a lot of emphasis on -- projected rent growth and economic vacancy. While rent growth has been absolutely nuts over the last several years, we usually project 2% going forward. Looking at historical data, it obviously can drop, but as a long term average, we feel safe using 2%, especially with long-term debt giving us the ability to hold the property. We also do not project anything below 10% economic vacancy for a stable property in a decent C class area of DFW. We may use different numbers in different areas of the country, but using DFW as an example. This loss includes physical vacancy, loss to lease, bad debt, etc. We may have 25% yr 1, 15% yr 2, then for years 3-5 we'll use 10%. Hopefully we do much better than that, but it adds some margin for safety.
Hey Tom, how much does your money cost? If your cost of capital is 6%, you can't really buy at a 6% cap rate unless you don't care about cash flow. Right?
Hi @Drew Shirley , on the extreme value add I mentioned, our loan is 4.5%. That's a 5 yr note from a local bank, 5 yr term with 25 yr amortization. It still projects to cash flow anywhere from 8-11% over a 5 yr hold, with a total return of over 100% to the investors including capital gains at sale. It will hopefully hit the 5 yr goal in 2 years, but still working on it. Being a bank loan, we will not have a pre-payment penalty if we decide to sell before the loan is due.
On most other deals, we'll use fannie mae loans, which are currently running around 4.75 I think, but haven't checked lately. I did get a Freddie Mac quote last week at 4.32%, but they don't fund rehab so not our preferred route.
I agree it would be tough to buy at a 6 cap if debt were nearly the same cost, but that's assuming no improvement to the property, correct? If there's a clear value add to the deal, one would hopefully far exceed the difference between your going in cap rate and the cost of your debt.
Your interest rate is 4.5% but your cost of capital is higher unless you're paying interest only. On a 4.5% loan at 25 year amortization, your cost of capital is 6.67%, in fact (yearly payments of principal and interest on a $1MM loan are $66,699.90).
I understand you're buying for the value add and the re-sell, but I'm going to have investors with a preferred return, so I need cash flow on day 1. I want to buy value-add but I never want to assume I can improve the property.
@Drew Shirley , yes we are interest only on about a $3M loan. I will assume we can improve the property if there's a very clear reason for it. In this case, there were over a dozen down units that had been that way for over 10 years, rents were much lower than surrounding properties that did not have units as nice as what ours would be when renovated, and it had absolutely terrible management. I'm absolutely fine assuming we will be able to improve over those conditions.
The investors in this deal have straight equity, and no preferred return. They knew there would likely be no returns for a while, so hopefully I can deliver on the end goal! Actually it is making money now, I'm just hanging onto it for a while longer as we finish up some unit rehabs, an office remodel, and a burn unit that could be pretty costly.
Tom what is your sponsor promote since no pref?
My structure I like is pref to equity group of XX percent non-compounded and then 50% promote on the back end.
@Tom Lafferty Sounds like a great deal! Good luck.