Updated: Jan 9
As the nation waits tensely to see the impact left by the COVID-19 virus throughout the United States, major capital market players are continuing to do the same. With the months of May & June being highlighted as potentially encompassing the height of the virus’ impact on collection levels, there is no question that markets will remain volatile until uncertainty clears around the spread of COVID-19.
In the following, I’ll walk you through three main topics many real estate investors are focusing on given the current state of our capital markets:
· Should I invest now?
· How would I go about doing so?
· What are some factors a passive investor should be searching for in order to fully analyze the strength of an investment?
I’d like to share with you more info on these factors, and how you can best use them to navigate today’s investment landscape brought on by the impact of COVID-19.
Should I Invest Now?
Many investors may feel that current conditions are not prime for deploying capital towards the commercial real estate asset class. The first issue is that given current market volatility, it’s challenging to determine the correct fair value to set as an offering price for a given investment. Pricing a property is broken down into two factors: Net Operating Income (“NOI”) and the Capitalization (“cap”) Rate. NOI is equal to the property’s NOI less it’s operating expenses (not including mortgage financing and other non-operating costs). Dividing the NOI by the price of the investment will yield the cap rate. The cap rate can be interpreted as the annual rate of return that an investor would be willing to earn per year in exchange for the risk of owning a property at that price.
NOI is currently volatile due to the potential impact of COVID-19 on tenants’ ability to make their rent payments, resulting in high delinquencies. The math is simple: the higher the unpaid rent amount, the lower the NOI, which results in lower property valuation. If NOI drops in the future from vacancies and delinquencies, the resulting fair price to pay for the property would be driven lower as a result. This is where many investors are struggling to discover a fair price to pay for prospective investments: NOI is too speculative to forecast since we don’t really know how much a property can collect in rents in the next several months, due to the Coronavirus.
How can we forecast the right NOI to discount at market consensus cap rates for this area in order to determine the correct price to pay? This would result in assets being offered at below-market prices. The issue of determining price is a very challenging task because we need to understand how much NOI will change in response to the uncertainty of future collections, and how much the fair price would change as a result.
The good news is that April collections turned to be better than expected, with a national average of 93% of March collections. We still need to wait and see what May collections will be to understand how the virus truly impacted a certain property.
Another issue is the relatively unattractive terms at which lenders are structuring their debt. Despite the Fed lowering interest rates, lenders have increased theirs in order to compensate them for lending in such an uncertain environment. Additionally, their required DSCR (debt coverage ratio, which is the ratio of NOI to debt payments) ratio is increased from 1.25x up to 1.35x or even 1.55x. LTV (loan to value) ratios are also being lowered from 75%-80% down to 65% and 55%. All three of these measures result in lower returns and higher upfront capital, which makes it more challenging to find and invest in attractive deals.
The final issue has to do with long-term ramifications of the COVID-19 outbreak. Nobody in the world currently knows when this will end, when we will return to our daily lives, or even whether there will be a secondary outbreak. This is resulting in a wide range of potential opinions, and naturally is sparking uncertainty in buyers, and low deal transaction volume as a result. However, Blue Lake is starting to see a window of opportunity presenting itself due to inefficient markets caused by the lender, buyer, and seller uncertainty. Return is made in real estate from buying assets at advantageous prices, and deals are finally beginning to come through at attractive prices as a result of market uncertainty. Blue Lake’s investment mandate is built around a fundamental value-based approach, i.e. buying only when market prices reflect or even are below their fair values.
As such, we’ve retained a conservative mindset through recent cycles of rampant overvaluation in hot markets, only buying when the offered price met our fair value requirements. Market downturns are notably the best environment for value-oriented investors, which can be seen by the returns and wealth built by investors and investment firms with similar mindsets during the downturn of 2008.
How to Invest in a Volatile Market?
The goal is to be extremely conservative, analyze all risk factors, and make sure to put emotions to the side when considering a new deal. When looking at a deal, make sure to leave extra slack in your projected operations to account for the potential of short-term instability without neglecting the long-term potential of the investment. Some of the adjustments to projections we are making at Blue Lake to account for our unprecedented time:
- We review returns assuming no rent increases for 12-24 months
- We assume a higher bad debt (delinquencies) up to 4 times as much as current delinquencies
- We assume 2-3x higher vacancies
The bottom line is that investors need to be comfortable with balancing the weight of potential short-term risk with the weight of potential long-term rewards when examining a transaction.
What Factors Should You Look for as a Passive Investor?
Here we’ll outline 7 general factors that each passive investor should consider when looking at a deal.
Factor #1: Deal’s Debt Terms and Structure
The first factor is the debt terms of the deal. Understand whether the deal has a fixed rate or a floating interest rate. A fixed-rate debt is far less variable and thus safer than floating-rate debt. Also, look to confirm whether the loan is conventional or a bridge. A bridge loan is usually short term (1-2 years, though can be longer), which means you’ll need to refinance the deal once the loan matures. Returns might be better in the short term with a bridge loan, but there’s uncertainty with future debt terms in a few years, since nobody knows if you’d be able to refinance with 3% interest rate or 5%, for example, and that can significantly affect your bottom line.
Factor #2: P&L Analysis
Profit & Loss (“P&L”) statements are also important factors in evaluating a real estate deal. Ask your syndicator to see the current P&L and compare it to the projected proforma. Look at current property’s vacancies, bad debt (delinquencies), and rent collections and compare those numbers to the proforma; if there’s a huge increase in income (say, 25%), ask if this is reasonable and why the syndicator thinks they can get there, especially during a pandemic. I’m not saying it’s not possible. All I am saying is that before you invest in a deal, you need to feel comfortable with the syndicator’s plan to grow the income.
Factor #3: Exit Cap
The third factor is the exit cap rate, which is the rate of return investors pay for upon sale. Exit cap is the cap rate that the property’s buyers pay when the syndicator sells the property. Higher exit cap means lower real estate prices, and since we came out of a decade of prosperity, it’s only reasonable to assume that the market will not be as strong when you sell in a few years, and hence cap rates will expand, as real estate prices go down. So exit caps should be higher than in-place cap rates. In other words, the cap rate you bought the property with should be lower than the cap rate you sold it with.
However, if the market your property is located in has a turn for the better, it will be sold at a lower compressed cap rate in the actual future, in which case you reap the reward of extra return without taking any additional risk.
Factor #4: Capital Expenditure (“CapEx”) Reserves
Capital or replacement reserves is the money set aside for one time improvements to the property (such as replacing roofs, fixing HVAC systems, etc). You should pay attention to how much money the Syndicator plans to keep as Capital Expenditure reserves or “CapEx” reserves. A good rule of thumb is 10% of current budgeted capital expenditures to be saved as reserves. These funds protect investors and deal returns because they can be used as an operational fallback to address unexpected expenses. They can also be a source of funding in case vacancies or delinquencies are high due to COVID-19, though not ideal.
Factor #5: COVID-19’s Property-Specific Impact
The fifth factor is COVID-19 and its impact directly on the property. The way the property was already impacted by COVID is a good indication of how sustainable it might be from the next recession. Look for specific information about decrease in rent collections and an increase in delinquencies.
Obviously, if any tenants have been infected, or if inefficient preventative measures haven’t been put into place, this will reflect an additional risk to the buyer and yield a higher property-specific cap rate/lower fair value of the property.
Factor #6: The Business Plan
The sixth factor is analyzing the Syndicator’s business plan for the deal. If the Syndicator intends to spend money currently on renovating and turning over units, this is likely a red flag in a tight environment like today’s where liquidity and occupancy are key. Make sure to ask why this is still a solid business plan. Again, this is a red flag, but it doesn’t mean there’s not solid reasoning behind it. If possible, ask to see the underwriting for a case where there is no renovation plan, at least for the first 12 months, and see how that impacts returns.
Factor #7: Organic Rent Growth
The seventh and final factor is focusing on organic rent growth. Organic rent growth is increases in rents which are not derived from renovating units and pushing rents, but rather are simply derived from increasing demand in the local market or year-over-year inflation factors driving prices up. In other words, it’s growth in rent just by forces of the market, and not because you had to improve the units to “justify” rent increases.
In order to analyze the deal conservatively, best practices would be to analyze the deal with rent growth assumptions set at zero or very minimal for at least 12 months, since we assume it will take time for the market to come back to normal. If the deal still makes sense under these assumptions, then the return assumptions of your project are more aligned with and driven by operations, while simultaneously reducing correlation to market downturns, then you are looking at a solid deal.
There are multiple factors on the minds of investors asking if they should invest now, including short- and long-term operations uncertainty, as well as the impact of new financing terms. When investing in volatile markets, be sure to take a realistically conservative approach with emotions removed from the process of analyzing deals. As a passive investor, a good place to start would be to analyze the outlined 7 factors; debt terms, P&L analysis, exit cap rates, capital reserves, COVID-19’s property-specific impact, the Syndicator’s business plan, and organic rent growth.
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About the Author
Ellie is the founder of Blue Lake Capital, a real estate company specialized in multifamily investing throughout the United States. At Blue Lake Capital, Ellie helps investors grow their wealth and achieve double-digit returns by investing alongside her in exclusive multifamily deals they usually don't have access to.
Ellie is the host of REady2Scale , a podcast that focuses on the "APS" of real estate: Asset, Process, and Strategy. Each episode discusses how investors can scale their real estate portfolio and/or businesses.
She started her career as a commercial real estate lawyer, leading real estate transactions for one of Israel’s leading development companies. Later, as a property manager for Israel’s largest energy company, she oversaw properties worth over $100MM. Additionally, Ellie is an experienced entrepreneur who helped build and scale companies by improving their business operations.
Ellie holds a Masters in Law from Bar-Ilan University in Israel and an MBA from MIT Sloan School of Management.