When choosing to engage in real estate syndication, once you’ve allocated your funds for investment and are considering various opportunities, there comes a moment when you need to discern which deals to steer clear of and which to chase.
Maybe there are specific red flags to be mindful of, or essential details regarding the underwriting aspect that you need to understand to make a well-informed choice and that’s exactly why you’re here!
In this blog, we’ll guide you through the information an underwriter evaluates in a deal, highlight various risks, offer a variety of typical number ranges we regularly examine, and help you understand the fundamental aspects of the commercial real estate sector and the potential investment opportunities within it.
We want you to understand how our team conducts thorough research on every investment opportunity and delves even deeper into analysis for those that pass our initial scrutiny. Today, you’re getting an insider’s glimpse into the behind-the-scenes efforts.
The Importance of Underwriting
Picture underwriters as the benevolent guardians who act as your initial shield against poor investments, sifting through deals that aren’t aligned with investors’ criteria.
Our objective is to scrutinize every detail, leverage our accumulated experience, and guarantee that we seize the chance to generate value and secure excellent deals for our investors. Notably, when we assess a potential investment property, we make it a point to visit and inspect it in person.
The Drawbacks of a Highly Competitive Real Estate Market
At first look, a deal may seem perfect – perhaps it’s situated in an ideal location with a growing population, high average incomes, top-tier schools, potential for increased rents, and promising returns for investors.
The downside is that other investors are also eyeing these opportunities, leading to intense competition for these seemingly perfect commercial properties. Capital floods these markets, bidders from across the nation appear suddenly, and cap rates decrease, diminishing the appeal for us and our investors.
As with any investment, there are inherent risks – escalating construction and renovation costs, inflation, fluctuating interest rates, and even unexpected issues like plumbing problems.
What if we could share with you some strategies we employ to consider all these factors, ensuring that none of us invests time and resources in commercial real estate that doesn’t pay off?
Understanding When to Walk Away from a Property: The Specifics
In commercial real estate investments, your objectives are multifaceted. You aim to generate income, reduce your taxes, enjoy a hands-off investment while safeguarding your capital from loss.
To avoid the pitfalls of a poor real estate investment right from the outset, it’s crucial to discern quickly between a viable investment opportunity and a dud.
Regardless of the type of property, your ideal choice would be one that delivers the necessary returns and financial stability you seek within your desired timeline, all while minimizing risk. Our focus typically lies on value-add deals that promise a minimum of 16% IRR and 2X equity multiple over roughly a five-year period.
Some syndication business models might make sense over a shorter period, like three years, but these usually come with higher initial costs and mirror the cost and risk profile of a residential real estate fix-and-flip. These are ventures with high potential rewards but carry substantial risk due to extensive renovations.
If you prefer to significantly reduce your risk and maintain a long-term cash flow strategy, consider purchasing an already profitable property. This type of deal might be found in a newly constructed Class A or B+ apartment complex in top condition, needing no repairs and already generating monthly or quarterly returns.
Warning Signs for Real Estate Investors
To spot the red flags, always read between the lines, whether you’re browsing through pictures, walking through a property, attending a webinar, or perusing an investment summary.
Should you visit a property and find the pool closed during peak summer, that’s a cue for inquiry. If the property manager seems clueless about why it’s closed or when it will reopen, your alarm bells should ring louder.
Visible neglect like trash in corners, damaged walls or roofs, or poorly maintained greenery might indicate that property management is overlooking even more severe, hidden issues. It wouldn’t be shocking in such a scenario to find unhappy tenants and ignored maintenance inside apartments or potentially decaying structures.
Be wary of a property manager who’s eager to showcase positives but glosses over challenges or significant concerns about operational costs. Properties lingering on the market for too long or priced significantly below market value should also raise eyebrows, often indicating undisclosed problems.
We’d need a substantial return (at least 18% and 2X equity multiple) to justify completely renovating, changing tenants, and introducing new property management if we encounter such red flags. Essentially, we’d be building from scratch, and if the numbers don’t promise an IRR of at least 12 or 14, it’s not worthwhile.
It’s important to note that we don’t select projects solely based on IRR and equity multiples. We weigh the effort (and associated risk) required to make the property market-ready against the potential return. Increased effort (i.e., risk) should always correlate with higher returns, and those returns should be substantiated by solid data.
Evaluating a Potential Investment Deal like an Experienced Commercial Real Estate Investor
Still on the fence about making an investment? Let’s delve into the more technical aspects of the evaluation. Begin by examining the latest 12 month financials (T12).
Upon acquiring a property, anticipate potential changes in the expense profile. Be prepared for possible increases or decreases in real estate taxes, payroll, insurance, and administrative costs. It’s vital to understand how these changes might affect cash flows under new ownership.
Then, project the monthly income that is necessary and likely achievable to hit the business plan targets in terms of cashflow, equity multiple and IRR.
Then, benchmark the current rents and unit mix against similar properties in the area. This step is about identifying the latent value in the business plan by pulling comps. Essentially, you’re assessing whether the rent rates of comparable commercial properties in the vicinity can cover the costs of necessary improvements while still yielding profitable cash flow for this property.
Identify similar units, built in the same period as yours but already renovated, and use their current rates to project the potential lease rates for your commercial property.
Sample Calculations from an Underwriter
Imagine that post-renovation, we’re able to increase rent by $337 for each unit. Let’s say the cost for roofing, siding, updating kitchens and bathrooms, fixing the pool, and replacing all polybutylene pipes totals $170,000 per unit. This rent hike translates to an additional $33,700 in monthly revenue for the 100 units.
But property valuation is tied to the Net Operating Income (NOI) [Remember property value is equal to NOI/cap rate….a property with a $1 million annual NOI and a 5% cap rate is worth $20million]. Let’s say the additional monthly revenue of $33,700 translates into 16,000 in monthly NOI or $192,000/year. So the renovation costs are justified as they are paid back in year one, then after that the property generates returns of $192,00 each year. Also at a 5 cap, that extra NOI equates to an increase in property value of $3.84 million.
Exploring Different Financing Options
Ultimately, it’s crucial to assess our financing alternatives. If the existing cash flow is limited or if a higher level of leverage is needed, a bridge loan lender may be the best choice.
In selecting the appropriate financing path, we take into account the initial cap rate, the projected rent hike, and the property’s present cash flow. If you approach an agency lender, you’re likely to encounter a more rigid repayment schedule, lower leverage and higher exit fees. Although these lenders typically offer the lowest interest rates, their lower flexibility and the high exit fees to sell a property early are major downsides.
Benefits of Opting for Bridge Debt
Utilizing a bridge loan from a debt fund might be the most advantageous route, as mentioned, when there is lower cash flow or if higher leverage is needed. The perks of a bridge loan include variable interest rates, minimal or no prepayment penalties, brief loan terms, non-recourse funding, and the chance for higher leverage exceeding the typical loan-to-value ratio of agency loans (these are from Fannie Mae and Freddie Mac and typically have leverage that is 5 to 10 points lower than bridge debt). These features make bridge loans an attractive option for investors looking for flexibility and higher borrowing potential.
The Drawbacks of Utilizing Bridge Loans
The primary downside to using a bridge loan is the higher cost associated with it. Bridge loans come with increased upfront fees, as well as higher interest rates, to compensate for the elevated risk they pose to lenders. These additional expenses can be significant and need to be carefully considered when deciding if a bridge loan is the right financial tool for your investment. Additionally in times of rapidly rising interest rates like we have just experienced, a major downside is the cost of funding the added interest cost and/or the cost of rate caps to hedge the upside cost.
Assessing Potential Earnings at Resale
Once we’ve nailed down our expenses, financing, and some key figures, our next step is to project the property’s potential selling price around 5 years post-renovation, by which time the upgrades are complete, and tenants are paying market rates.
For this hypothetical property, let’s say renovations wrap up by year three and the property is stabilized. Our initial Net Operating Income (NOI) was around $1.1 million, and by year three, it’s approximately $1.6 million, indicating we’ve generated an extra $500,000 in income.
At this point, we consult with brokers to gauge their opinions. After inputting the anticipated selling price, purchase cost, renovation expenses, and increased rent as advised by the brokers, we find ourselves looking at a 12 percent Internal Rate of Return (IRR) and 14% annual return for limited partner investors.
Weighing the Returns: Is the Investment Worthwhile?
In this case, we would decide against proceeding. Considering the availability of less risky and more lucrative commercial real estate investments, the projected returns here don’t sufficiently appeal to our investors.
There’s no definitive benchmark for what makes returns “excellent.” The market, economy, tenant demographics, management costs, taxes – virtually every factor – is constantly evolving. Cap rates had been falling for the last decade prior to Covid and were pushed down even further by Covid. But with the historic rise in interest rates starting in March 2022, cap rates have been on the rise and are not projected to start declining until mid-2024.
Ultimately, the potential success of any commercial property investment should be evaluated based on its risk-adjusted return. Comparing returns against the level of risk your capital is exposed to is crucial, taking into account the deal’s class, location, and business plan. Generally, higher returns are indicative of higher risks.
Deciding When to Reject a Commercial Real Estate Investment
By now, you’re acquainted with the early stages of commercial real estate investment evaluation, which give us a clear yes or no as to whether we should delve deeper.
If we’re facing substantial renovations with an anticipated 14% IRR or minimum 16% average annual return, the venture doesn’t meet our criteria or that of our investors, prompting us to move on to the next potential investment. Conversely, recently leased-up new construction requiring minimal renovations with a 14% IRR or 16% average annual return might merit further investigation.
Essentially, determining whether to proceed or halt at this juncture in the investment process is straightforward!
While today’s focus was on a multifamily scenario, the same analytical approach applies whether you’re considering retail spaces, storage units, hotels, industrial facilities, or any other type of commercial real estate.
By the time a potential commercial real estate investment opportunity lands in your inbox, the GrowAbility Equity team has already conducted this degree of due diligence, along with sensitivity analysis and additional number assessments to help us secure the contract, finalize the transaction, and prepare the documentation.
If you’re interested in diving deeper into our deal flow, we’d be thrilled to have you join the GrowAbility Equity Club. We can also schedule a call to better understand your investment goals and guide you toward achieving them!
Thanks for being a part of our community. Until next time, keep growing your ability to accelerate your wealth and legacy building—we’re thrilled to be a part of this journey!