5 Caps - What kind of returns can I expect

I have a question regarding what kind of returns I can expect from underwriting multi-family value add acquisitions at a 5 cap. I am typically in the neighborhood of low double-digits IRR, CoC mid-single digits.

Some basic assumptions:
10 year hold
stabilized vacancy(5%) entry cap = exit cap
Leverage - 4.5% IR, 1.25x DSCR, 5 years IO
Value add program post stabilization adds ~10 mil. in value (500k in perpetuity discounted at a 5% cap)
Expense growth - min of 2% or rent growth
rent growth assumptions are from REIS - typically between 2% and 4%/yr
5% vacancy

What kind of returns do you guys generate?

 
Best Response

I'm not going to open excel right now but a few comments: -When I'm doing a 10 year hold and its not in an OM, I like to bump the cap up by about 50 basis points given that I don't believe that these ulta-low interest rates will be the same in 10 years (I do believe we are in a new low interest rate environment but not as low as it is right now). So my exit would be a "conservative" 5.5% (obvious depends on market but for the most part this stays true for MY analysis--is this a sexy 6 CBD?). Additionally, it looks lazy and "out of touch" when you match your entry cap with your exit cap. Give the investors your opinion based on your past experiences. -Your loan terms surprises me and I'd like more clarity. 5 years IO at 4.25% and it all comes expire as a massive balloon in that 5th year? Have you run this by a bank or whoever you plan to loan from? Those terms are just something that I would not see in my market, that's all. -Conservatively, I would match your expense growth with your rent growth. This is safe and given the rising cost in construction/contractors, its probably more in that ballpark than just 2%. -What value adding are you doing? Lobby demo? Doesn't seem like your getting your added value in increased rent aka renovated units as you indicate your market rate increases at 2%-4%. Where is the $500k coming from? --------If I were to plug all of your assumptions into a CF, I bet I'm well within the double digit IRR that you're looking for and its probably not even residual heavy. This makes for good discussion---nice post!

 
cre123:

I'm not going to open excel right now but a few comments:
-When I'm doing a 10 year hold and its not in an OM, I like to bump the cap up by about 50 basis points given that I don't believe that these ulta-low interest rates will be the same in 10 years (I do believe we are in a new low interest rate environment but not as low as it is right now). So my exit would be a "conservative" 5.5% (obvious depends on market but for the most part this stays true for MY analysis--is this a sexy 6 CBD?). Additionally, it looks lazy and "out of touch" when you match your entry cap with your exit cap. Give the investors your opinion based on your past experiences.
-Your loan terms surprises me and I'd like more clarity. 5 years IO at 4.25% and it all comes expire as a massive balloon in that 5th year? Have you run this by a bank or whoever you plan to loan from? Those terms are just something that I would not see in my market, that's all.
-Conservatively, I would match your expense growth with your rent growth. This is safe and given the rising cost in construction/contractors, its probably more in that ballpark than just 2%.
-What value adding are you doing? Lobby demo? Doesn't seem like your getting your added value in increased rent aka renovated units as you indicate your market rate increases at 2%-4%. Where is the $500k coming from?
--------If I were to plug all of your assumptions into a CF, I bet I'm well within the double digit IRR that you're looking for and its probably not even residual heavy. This makes for good discussion---nice post!

Adding 50 bps to the exit cap would only hurt returns

We invest in 2nd and 3rd tier markets normally.

5 years IO with a 10 year term, 30 yr amort schedule. ballon payment is at end of year 10. IR = 4.5%. This is based off of (recent) quotes we have gotten from the agencies. These are quotes for properties we were looking at in Texas and Colorado. We recently looked at a property in a rather small but stable south western market and we were between 4.7-4.8%(dependent on treasuries) for 7 years IO 10 year term.

Again, matching expense to rent growth would only hurt returns. I am trying to understand why my IRR/CoC is low DD/mid SD given my current assumptions.

Value add is pretty standard stuff. It is typically based off of what some of the comps are doing. We are certainly no trailblazers in this field. examples include: adding washer/dryer, granite countertops, upgrading appliances, lighting, flooring, cabinetry, and maybe some other random or property specific stuff.

500k = # upgraded units * avg. expected monthly rent increase ex: 242 units to upgrade at $175 in monthly rental premium from upgrades 24217512 = ~500k

 

Adding 50 bps to the exit cap would only hurt returns

No kidding, its being conservative.

We invest in 2nd and 3rd tier markets normally.

5 years IO with a 10 year term, 30 yr amort schedule. ballon payment is at end of year 10. IR = 4.5%. This is based off of (recent) quotes we have gotten from the agencies. These are quotes for properties we were looking at in Texas and Colorado. We recently looked at a property in a rather small but stable south western market and we were between 4.7-4.8%(dependent on treasuries) for 7 years IO 10 year term.

Ok I'll assume 80% LTV

Again, matching expense to rent growth would only hurt returns. I am trying to understand why my IRR/CoC is low DD/mid SD given my current assumptions.

Again, no kidding. Ironically, I don't get your confusion. You have a 5% cap rate and you're looking at a 10 year hold with no cap rate compression and 500k in increased per year in rental revenues. How much capital did you put in to do this value add? You're probably at a 4.5 cap after you're said and done. Pretend you value added for $0, you're at a 5 cap and with your 4.5 interest rate you're getting only a small amount of positive leverage in that first 5 year IO stint (Pretend 80% LTV, (5-4.5) * (80/20)= 2% then add the orginal cap rate onto it and you're at 7% leveraged return on those IO years. And, again depending on your LTV and you're constant, you're almost guaranteed to see negative leverage with that 4.5% interest rate when you start amortizing. Are you not familiar with how leverage or cash flows work? Why do you think a 5% cap rate with more equity thrown in for renovations coupled with a 4.5% semi-amortizing loan would see big returns. Its math. It doesn't

Value add is pretty standard stuff. It is typically based off of what some of the comps are doing. We are certainly no trailblazers in this field. examples include: adding washer/dryer, granite countertops, upgrading appliances, lighting, flooring, cabinetry, and maybe some other random or property specific stuff.

500k = # upgraded units * avg. expected monthly rent increase
ex: 242 units to upgrade at $175 in monthly rental premium from upgrades
242*175*12 = ~500k

Ok. How much does this value add reno cost the owner?

 

If you are only growing expenses at 2% expense growth (are you factoring in a reassessment, we've gotten nailed with these as municipalities track sales more aggressively?), then my guess is that the reason your IRR and CoC is low is that you are spending a ton on your rehab and any deferred items and that is weighing you down.

The debt terms seem to be market for those markets, and what we are seeing (granted we usually hold for ~7 years).

$175 average premiums are JUICY in secondary/tertiary markets, so I'd be careful there. Also, I'd caution against modelling that premium in perpetuity (I'll just leave this here (take the spaces out to read, http://www. multifamilyexecutive. com/business-finance/commentary/rehab-roi-do-the-math_o)

We bought a deal earlier this year in Austin at a 5.1% in place (late 2000's deal) and the aim is to exit at a 6% and a 2x EM.

 
cre123:

Agree to pretty much everything you've said. OP seems to be aggressive with assumptions. You're only lying to yourself with aggressive numbers.

"We bought a deal earlier this year in Austin at a 5.1% in place (late 2000's deal) and the aim is to exit at a 6% and a 2x EM." What do you mean by 2x EM?

EM=equity multiple
 
Count_Chocula:

If you are only growing expenses at 2% expense growth (are you factoring in a reassessment, we've gotten nailed with these as municipalities track sales more aggressively?), then my guess is that the reason your IRR and CoC is low is that you are spending a ton on your rehab and any deferred items and that is weighing you down.

The debt terms seem to be market for those markets, and what we are seeing (granted we usually hold for ~7 years).

$175 average premiums are JUICY in secondary/tertiary markets, so I'd be careful there. Also, I'd caution against modelling that premium in perpetuity (I'll just leave this here (take the spaces out to read, http://www. multifamilyexecutive. com/business-finance/commentary/rehab-roi-do-the-math_o)

We bought a deal earlier this year in Austin at a 5.1% in place (late 2000's deal) and the aim is to exit at a 6% and a 2x EM.

Yes, I should have said controllable expenses and insurance are grown at the min of 2% or rent growth.

With taxes, we are very meticulous. We call an assessor for assumptions and as we get deeper into due diligence we will speak to consultants.

The rehab numbers I was giving before were rough - we will assume the rehab period over 2-4 years so saying into perpetuity isn't entirely accurate until the property is stabilized.

For the example I gave, the rehab premium was based off of units that have undergone renovations with the current owner. This particular market is a west coast location with a lot of tech exposure.

 

What is your rehab costing you per door? With everything you are saying and as aggressive on your assumptions as you are, there are really two reasons why your returns are low that I can figure. First, you are spending too much on your rehabs and the premiums you're getting somehow are not enough to get you to the cash flows you need for the deal to pencil. Second, the premiums not being fully done as fast as possible (220-ish units should take you no more than 20 months if your ops and construction people are legit) prevents you from hitting the cash flows you need before you start paying principal. I'm sure there is something else I am missing but from my sofa drinking Rolling Rock, that's where I at.

 

Not to disown or discredit anyone's answer to the OP's questions, but I'm wondering why there's so many variations to his question? Is it because of lack of initial information leading to individual assumptions and different end results? Is it the value of assumptions varying widely due to market experience?

Just wondering as I'm trying to break into Commercial Finance and am trying to keep up with the thread and understand each individual method and the reasoning behind it.

 

CMBS are priced on swaps. Some banks/lifco do T note some do swaps. can tell us what the benefit of using 1 of the other is. I doubt there is a benefit just a "that's how we do it here" type answer. They all need to stay competitive so they probably have different markups over the t note vs over the swap. Am I right? I'm on the equity side so I'm always learning from the lenders I get quotes from.

 

Yes, generally there are different spreads depending on what the lender is pricing over. Right now, swaps and treasury is close that they aren't that different, but that may not always be the case.

Pricing over treasury is just something that is tradition for a lot of portfolio lenders/life cos. Probably because most life company lending predates the creation of interest rate swaps and nobody has ever changed it, while CMBS is a relatively new financing construct.

 

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