Who is buying this stuff? Brokers and PE analyst/associates

Brokers are doing their job well. In an environment where deals fall through off rising rates, which I assume means they were too sensitive to debt anyway, properties are trading at cap rates where even with aggressive leverage, they will likely deliver sub 15% IRRs, and sub 8% coc returns after fees, if you're following a traditional PE model.

The only way I realistically see these metrics being surpassed is if rent growth rises yoy, with little investment into a property, so basically buying a product and expecting it to rise in value without changing it. Which is fine, but I fail to see how so many 'PE' groups continue to place capital.

The idea behind a PE investment is that the group's expertise will be used to create an asset that will be able to deliver returns superior to those of traditional public equity and alternative markets.

Question for brokers working with institutional clients or family offices; what is the rationale of clients making investments into sub 4 cap properties? Are all of these going to local guys looking to preserve family wealth, or some other strategy that does not look for short-term returns? I'm trying to better understand competition and their perspective.

Question for young guys working in PE; how are your bosses selling sub 4 or 5 cap properties to LP's or large investors in your fund if the retail-price tag on most assets in most classes has close to negative leverage without major overhauls, which implicitly bring on more risk, and will deliver sub 20% IRRs?

Taking a broker's underwriting package might get there, but almost without fail, every broker underwriting i've seen misses details material to returns/the deal, or assumes rent growth with little investment in a market with no wage or job growth.

Am i thinking about this too much, or am i missing something? Would love to hear some thoughts.

Comments (38)

Funniest
Jun 5, 2018

Few thoughts on this (apologies in advance for the stream of consciousnesses nature of this):

  • Most of the guys falling out are the local HNW folks banking on higher leverage and proceeds with inadequate cushion in their rate assumptions. That's why you vet that shit during B&F.
  • As you likely know, there can be a ton of noise in cap rates. A lot of people are showing pure year 1 cap rates that are sub-4, but maybe operations aren't great or the market is on the tail end of a supply wave and the buyer expects to "stabilize" operations for a "stabilized cap rate" of say 4.25%.
  • Some people are compressing their exit cap assumptions and basically banking on greater asset appreciation as a way to hit return hurdles.
  • We'd all like to beat the public markets, but that's not why our LPs give us money. We're a fractional allocation in their overall portfolio and our funds are a way for them to meet their allocation targets. No one expects us to hit 20% IRRs on all of our funds. If you're a fund manager raising a fund every two years or so, you're going to have some vintages in that series that don't hit the ball out of the park. The key is to manage downside in those situations and market perform and then outperform when things get better. The syndicators are the ones that get hurt in a market like this; generally not the folks with permanent capital (generally).

That's my two cents on some of your questions; that and two dollars will get you a cup of coffee.

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Jun 5, 2018

Well said, especially the exit price note.

Jun 5, 2018

Who would buy into a compressed exit cap? I cant see any PE players I work with, or any family office with an ounce of experience expecting a 6.5 cap to compress to a 6 at exit in 3-5 years in a good market. They would literally laugh, or at least hit you with a "oh... okay.."

Unless you're completely changing the class of the asset or something, which then would require a risk adjustment in the analysis.

I guess that is what I'm looking to find out; who is buying this kind of stuff? Also - would they be looking to place more equity with a guy off the internet?

Jun 7, 2018

Just the whole concept of a 4% cap rate makes me so angry I could punch a corrupt foreign politician in the mouth.

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Jun 5, 2018

In the sub $15MM space, it's a combination of syndicators, family money, 1031s, etc... Lots of unsophisticated players that are keeping exit cap rates at sub 6 on class B/C product.

Also, and this may be more disconcerting, I'd say 70% of the market doesn't attempt to model future tax increases as a result of revaluations. I know a number of investors of a certain religious faith that were recently crushed by tax increases because they only underwrote year 1 cash flow and tossed in the offer.

I can't speak to the institutional side of things.

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Jun 5, 2018

There is a ton of capital on the institutional side that needs to buy deals and is leaning in on their assumptions very aggressively or just deciding to accept lower returns in order to remain active in the market.

I don't understand people who don't model the tax growth based on purchase price reassessment. Every municipality is tracking sales and slapping assessments as close to 100% of the sale price as possible if not more. Not underwriting that is just lying to yourself and your investors.

Jun 6, 2018

Fannie & Freddie don't buy it either, they underwrite to the reassessed value for tax purposed and will size your debt accordingly.

Jun 6, 2018

Great insight. So as the broker, was this touched on? Did your group broker a deal like this? Immediate thoughts are that there is a huge lack of financial advisory in the space leading to horrible decisions, as they were no necessarily looking for bad returns, but were not advised on a specific nuance to the industry.

Hmm...

Jun 6, 2018

Our group (multifamily LP) has made it to the best and final rounds on many deals over the past few months, we typically lose out to family offices who can stomach lower coc returns, longer holds, and who are willing to put down up to $1mm hard money DAY ONE. It's insane.

We have lowered our return thresholds slightly, as well as lowered our exit cap rate expansion assumptions in our underwriting. Currently fundraising our next fund and making no changes - our past two funds are outperforming very well (albeit, who isn't). I think the multifamily story continues to be a strong one, and if you can get good product in good locations under control, you won't get hurt (we do not anticipate any homeruns at this point in the cycle).

Jun 11, 2018

Also working for a multifamily REPE shop and would like to echo the insanity of hard-money that' reality as of late.

Jun 11, 2018

Agreed that the day 1 hard money dynamic is insane, but I remember seeing that in the southeast 3+ years ago. When we're selling, we usually aren't impressed by it as much as you'd think, because more often than not there are huge loopholes that allow the buyer to get that money back. Our "decision tree" always works as follows:

  1. Who are our top 3-5 groups?
  2. What is the spread on price between them? If greater than $500k we take the high flyer risk.
  3. If no gap, have we done a deal with one of them before? If yes, they get the deal; we use old PSA as a form.
  4. If no, has the broker done a deal with them? How did they perform?
  5. Simultaneously, do we know them personally or do people we know personally vouch for them?
  6. Control of capital (1. all-cash, 2. discretionary capital that they truly have control over, 3a. programmatic separate account, 3b. JV with an institutional capital partner where they already have JV docs and I want the partner on the B&F call, 4. 1031 exchangers with the money in the ID account, 5. HNW syndicators with a track record, 6. "oh fuck this didn't go how we planned, maybe we should relaunch in 6 months", 7. everything else)
  7. Do they have their debt flushed out, and how much cushion do they have in their interest rate assumptions?
  8. Timing (shorter DD and closing are helpful, but 30 day DD and 30 day close is fine too. We don't really care about this too much unless someone can move really quickly or just close all cash at the end of DD.)
  9. Hard Money
  10. Other shit

I've likely missed a few elements, but it all comes down to surety of close at the agreed upon price. I'll take the devil I know vs some schmuck I don't that is willing to pay $100k more. If it is a $500k+ variance, then I'll hold that moron's hand through DD, but otherwise he can get fucked.

Jun 13, 2018

Story of my life the last six months. Hard money day 1, 10 day DD on $100M+ assets with huge renovation. Not really sure how you compete with that at this point in the cycle, nor want to.

Jun 6, 2018

If you are a fund manager at a pension fund, your investment philosophy is "overpay for quality real estate". A mass marketed core deal with nothing funky is going to have plenty of these types ready to back up a dump-truck of kindergarten teachers retirement money to close the deal. Especially now 6 months into the year, if you are still sitting on a lot of capital to deploy, you will up your bet and pray some foreign capital that just wants to watch the world burn doesn't snag it in best and final.

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Jun 6, 2018

This. I think I mentioned this somewhere a few months ago but we've literally been in situations where we tell our investors/clients of certain separately managed accounts that they shouldn't buy this deal because of the anemic returns, and they basically say 'fuck you just buy it, we need to generate cash flow'. All these groups care about is coupon clipping/cash flows since they plan to hold it for what might as well be forever; they aren't concerned about an IRR/exit.

Jun 7, 2018

How do you structure those deals to make them work from your perspective? Are you able to juice your returns through management fees? On ultra-low cap deals, we're getting to the point where leverage is neutral at best and curious how (or if) operators are able to squeeze a 6% out of a 4% cap...

Most Helpful
Jun 7, 2018

The only way to really make money in this market is through seeking out opportunities where you see a market shift which will lead to rent growth or through active investments into an asset. The funds who are making extremely high returns are seeking investments where they can do both. Boots on the ground and changing a market is how you make real money in this industry. Real estate values are intertwined with index rates and as they rise values fall. So dumb money buying core assets aren't going to do so well in our current environment. In my view, we are at a crossroad where less sexy real estate that trades at lower multiples (IE 10 CAP deals) are less risky than core assets where small incremental macro market changes can kill value. I personally am still bull on the market and still see opportunity but am only looking for deals where I see large market changes occurring.

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Jun 7, 2018

'Market Changes' is a pretty broad phrase to describe a lot of detail. Could you expand on particular details that you pay attention to? For instance, are you looking at a macro view? For instance, prospective markets that large corporates like Apple and Amazon may expand into (Nashville, DC, Charlotte, Atlanta)? Or are you focusing on more micro-level factors, such as political shifts in regional elections (an ex. would be local policy changes or lack of political movement in SF leading to worsening housing situations and pushing residents to the east bay).

    • 1
Jun 7, 2018

Just go back and study what happened when Met Life sold Stuy Town to Tishman Speyer.

https://en.wikipedia.org/wiki/Stuyvesant_Town%E2%8...
Everyone always models ever-increasing rents and no one ever models a recession.

So I ask you this...is there another $5 trillion in QE coming to keep the market going?

Or, does the business cycle still exist and are we in for some contraction?

In a business where people only get paid for deals that get done there will always be people overpaying at the top, which is what is happening now.

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Jun 8, 2018

The liars ball is a good book on that deal

Jun 11, 2018

This

Jun 12, 2018
Port Ricky:

Just go back and study what happened when Met Life sold Stuy Town to Tishman Speyer.

https://en.wikipedia.org/wiki/Stuyvesant_Town%E2%8...
Everyone always models ever-increasing rents and no one ever models a recession.

This isn't a great example. The problem at Stuy-Town wasn't decreasing rents or a recession or anything like that, it's that Tishman was breaking the law and illegally turning units to market rate when they weren't allowed to. Their mistake was in assuming that there would be more aggressive turnover of rent stabilized units, and growing rents to market from there, and not in the rate of growth of rents in general. Once they realized that they weren't hitting their numbers on organic unit turnover, they started doing some shady shit to make their numbers. Which is why developers get a bad reputation in NYC.

Jun 12, 2018

uhhh...so the part where I said "Everyone always assumes ever increasing rents" doesn't cover this? Meaning, they justified their bid by assuming they could raise rents?

Also, show me a listing for a building with stabilized units for sale in NYC that isn't screaming about "Massive upside in rents" somewhere in the listing? Again, because everyone who thinks prices make sense now are modelling taking units to market, regardless of legality.

Kind of like when you buy a house in the outer boroughs and they want $1.1mm for some shack and the ad says "2 family, 3 kitchens" Wink Wink - current valuations are only justified by renting out illegal basements. Hell, I remember when I was shopping for a house and ads would literally say "You can rent spaces in the driveway for $75". Yes, the justification for a million dollar house now is that sweet, sweet $75 a month I can collect for that 93 honda with the open exhaust leaking all over my driveway. The whole market in NYC is an obscene joke...

    • 2
Jun 7, 2018

Sub-4 cap rates........ welcome to Cambridge, MA

Jun 14, 2018
Mr. Deeds:

Sub-4 cap rates........ welcome to Cambridge, MA

I'm refinancing a property in Somerville right now we are DSCR limited to a 1.2 but the LTV is going to sub 60% based on the appraisal. I think they used a 3.75% cap rate. I don't get it

Jun 11, 2018

The 10 year is almost at 3%. The day it gets to 4%, those buying RE at 4 caps are going to be dead men walking. Hold it out, let these people get crushed. Let the pension funds and family offices lose value, I won't shed a tear for these people when the market crashes. The problem with the human brain is that everything is short-term. We are at 9 years since the bottom and people have pretty much forgotten about basic economics. Turn on CNBC or Bloomberg and notice how every analyst looks like they are on Fentanyl and paint a rosy picture.

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Jun 12, 2018

Long-term holders with fixed-rate debt don't care. Merchant builders and flippers will get hosed.

Jun 13, 2018

This. Cautious optimism. Had a guy over dinner trying to explain to me how they're willing to take core returns on value-add deals and comfortable with the price/return metrics. Literally felt like that scene in the Big Short where Steve Carrell is at the Vegas mortgage conference and he thinks everyone but him is crazy. But hey, at least I know where the dumb money is.

Jun 14, 2018
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Jun 11, 2018