If you would have asked me in early 2020, “what type of returns does PassiveInvesting.com typically try to achieve on your multifamily investment offerings?”, I would have told you that we are typically projecting 14-15-16% IRR (see online article explaining the IRR calculation in our knowledge center on our website) for a 5-year hold time period. This is not the story as we move into the mid-2021 multifamily market.
The 2021 multifamily market has proved to be a strong, tight market which is causing the returns to go down. This type of market is great for investors that are selling, but it also causes the return projections to go down. On the most recent deals that we have been analyzing the returns are coming in at 11-12-13% IRR on a 5-year time frame.
Falling Cap Rates
The cap rates in the markets we are acquiring assets have been falling. One of the factors that causes this to happen is the strength of the market causing more investors to come to the area to invest. This increased competition causes the cap rates to fall in a market.
Another reason the cap rates have been falling is that the interest rates have been at all-time lows and debt is very cheap right now. The cheap debt causes the cap rates to fall since investors are willing to pay a higher premium for properties since the debt is lower.
The Federal Reserve is projected to continue to keep interest rates low which will again cause the cap rates to stay low. This is great for assets which we will potentially be exiting this year as the exit proceeds will be much higher than originally projected.
Right now, we are seeing most cap rates in our markets coming in at sub-4% but it is not too far off for us to start see the cap rates falling in the sub-3.5% area. Strong markets, like the ones we invest in, I believe will eventually turn into sub-3% cap rates if the interest rate environment continues as is for an extended period. These sub-3% cap rates are also being driven down due to the strength of the sub-market economics with increasing job growth, expansive economic development, exploding population growth, population migration, et cetera.
Manipulating the Underwriting to Show Higher Returns
There are many ways to manipulate the underwriting to show you that we are achieving higher returns such as the higher returns that we saw in 2019. Our goal when underwriting is to be moderately conservative so we can under-promise and over-deliver for you. We would rather project a 11-12-13% IRR and exceed that to a 15-16-17% than projecting higher returns without being able to hit those higher returns.
Here are a few ways that the underwriting can be manipulated to show higher returns that are hardly achievable in this current environment:
Rent Growth: The rent growth assumptions could be way over what the market can bear to show higher returns. The rent growth assumptions are what allow the asset to achieve higher cash-on-cash during the hold period since the rents throughout the hold period are higher. It also allows for overall higher returns but the primary reason for projecting higher rent premiums is to show greater cash flows.
Our rule of thumb in setting rent growth projections after value-add renovations is to not be the market leader. We want to set our projections so that we are in the second or third position based on the other competitor properties in the market. Now this doesn’t mean that we won’t try to be the market leader once we close on the property but in our projections, we would rather be conservative in our rent growth assumptions.
Exit Cap Rate: The exit cap rate is a commonly used metric that is manipulated to show higher returns. One thing to keep in mind is that the exit cap rate assumption has no bearing on the cash flows during the hold period. The exit cap rate assumption only influences the projected sales price when ready to sell at the end.
Projecting a lower cap rate allows the property to show a higher return and projecting a higher cap rate allows the property to show a lower return. Since we are buying stabilized (above 90% occupancy) assets with little to no major deferred maintenance, we conservatively expand our cap rate on exit to at least 50bps (0.50%) higher than the entry cap rate. For example, if we purchase a property with a 4.5% cap rate, our exit assumptions will be at least 5.0% on the exit cap rate assumption. This type of conservative approach allows us to have added room for error. This is because the markets that we acquire assets will likely continue to be strong when we are ready to sell the asset and we will likely be able to sell our assets for at or below our entry cap rate.
In the newer, class A assets, this may differ as the business plan will be different. For example, we may acquire 2018 build assets with no renovation plan and hold onto it for 7-10 years. By the time we are ready to sell the asset, it will be perfectly poised for a value-add group to acquire. This would allow for a lower cap rate due to the amount of upside potential that is available on the asset for the new buyer. Even in this scenario, it is smart to project a higher cap rate upon exit to be conservative, but the exit cap rate projection might be less than our normal rule of thumb of the 50bps spread between the entry and exit cap rate assumptions.
Vacancy Assumptions: There are two major vacancy assumptions that must be looked at closely when underwriting a large apartment deal. First, there is the renovation vacancy which is the projected vacancy rate while we are performing renovations. Our goal during the renovations is to maintain a certain occupancy so we don’t hinder the cash flows during the renovation phase. This assumption is usually projected based on the blended historical vacancy of the property and the average vacancy for the surrounding sub-market.
For example, if the average blended vacancy for a 300-unit property is 5% then we calculate the projected renovations by multiplying 300 units by 5% which equals 15 units per month that are vacant. If we renovate all 15 units each month that are vacant then this allows us to renovate 180 units each year which will take us 20 months to renovate all 300 units. To allow us to renovate the units sooner, we typically can increase the budgeted vacancy to 7% which would allow us to renovate 21 units each month which would take us 14 months to renovate all 300 units.
Now experience has also told us that renovations don’t always go as planned so we typically add an additional 3-4 months to our renovation schedule to take into account discrepancies in the renovation schedule. Depending on the number of units being renovated, it will typically take between 12-24 months to fully renovate all the units in a property.
Other Income: This category is like no other when it comes to underwriting in that any additional income from the property, outside of the normal rent collection, is added to this field. There are certain projects that we have successfully implemented on our properties which allows us to add additional income to a property with confidence. These added items include valet trash, package concierge, washer and dryer income, et cetera. Adding additional income to a property is great as it allows for increased cash flows, but we still need to be conservative here.
When adding other income projects, it needs to follow the same gradual approach as the rent premiums during renovations. This is because it can take time to implement all of the projects on the property. When reviewing our proformas or other operators, you should always ask about this other income field to fully understand what the operator is planning for adding income to the property.
One exciting new option for added other income is a service that allows resale the internet to the residents. The the property to become its own Internet Service Provider (ISP). The local cable or telephone service would install a fiber optic line to the property, and would be the service provider that installs all the equipment to make this happen would charge the property a small monthly fee per active user to manage and do the customer service. The property would be able to set the monthly fee to be competitive in the market. The bottom line is an additional $50-$75 per month for each user. The average utilization rate on the current properties is 70-80%. If we take the conservative approach and only underwrite to a 50% utilization rate, then it would be an additional $7,500 per month on a 300-unit property. This would allow for a $7,500 (300 x 50% = 150; 150 x $50 = $7,500) per month increase in net operating income (NOI) which equates to a $90,000 increase in the annual NOI. Our markets typically have at least a 5% cap rate which would equate to a $1,800,000 ($90,000 / 5% = $1,800,000) increase in the value of the property with just this one added other income project.
I explain these various methods above so you can be more educated when reviewing our projections in the future or when reviewing another operator’s projections. These are great items to address with future offerings with other operators prior to investing.
Diamonds in the Rough?
This article is all about how in the middle of 2021 you should be expecting to see lower overall returns on the assets that we put together. One final thought is that we still are looking for that diamond in the rough that will provide higher returns like we have seen over the past couple years. These deals are still out there, but they are few and far between. This should be the exception and not the norm. If every deal an operator goes out with has high, outstanding returns, then you must sit back and ask yourself, why?