Evaluate a Multifamily Deal
As the final part to the previous blogs, Evaluating a Market and the Sponsor, evaluating the multifamily deal itself is probably the easiest but nevertheless important in deciding whether the investment strategy (core, value add, or development) is appropriate for your portfolio. Do not just pick the deal with the highest projected IRR, it is just a wild guess at best.
Evaluating the Business Plan
Review the business plan and make sure the capex budget is sufficient. A couple of key metrics of interest are yield on cost which is the pro forma cap rate once the property has stabilized and a related metric called development spread, which is the difference between the yield on cost and the going-in cap rate. The development spread measures the amount of “value add” or the improvements made to the operations to force appreciation. The projected rents should be well supported by true comparable properties and similar unit amenities. It is also ideal for the asset to be located with easy access to major highways, retail, grocery, restaurants, etc.
Evaluating the Debt
It is important to understand the debt structure and determine its suitability for the business plan. It does not make sense to put on long term 12 year fixed agency debt if the plan calls for selling the property in 3 to 5 years after stabilization and incur steep prepayment penalties. Is the rate fixed or floating and if floating, is there a rate cap in place for the entire maturity of the loan? In addition, a conservative operator would keep excessive reserves not only for all major components of the asset regardless of the condition at the time of purchase, but also for working capital and contingencies for unexpected issues.
Evaluating the Underwriting
When it comes to underwriting, you will want to see conservative rent growth, reasonable expense ratios, and economic vacancy assumptions to make sure the operator isn’t making aggressive assumptions to inflate the projected returns on paper. Pay close attention to the insurance cost, property taxes, and if the property is in a flood zone which will require additional coverage and added risk. Is the operator using a reversion cap rate that is realistic or inline with long term historical average? Be aware that even a small reduction in the reversion cap rate can increase the projected valuation of the property significantly. What kind of stress testing / break even occupancy and sensitivity analysis has the operator performed? It is good to see how changes in occupancy, cap rates, or rent growths impact the investor’s returns.
Evaluating the Fees & Splits
As it relates to fees and profit splits, you will want to see that the fees are reasonable and that there is alignment of interest and skin in the game from the operator. Acquisition, loan guarantee, and asset management fees are typical, but capital raising, broker dealer commissions, and disposition fees are less common. Is the operator putting in their own money in the deal net of their fees, and signing on the loan? There are infinite ways to structure the profit splits or the waterfall, but one that is favorable to investors prioritizes the return of investor capital plus a high hurdle rate (preferred rate) before the sponsor gets to participate in the profit split, and incentives the operator to outperform but allowing a higher profit split if investor returns reach a certain targeted level.
Evaluating the Legal Documents
Carefully review the Private Placement Memorandum (PPM), Operating Agreement (OA), and Subscription Agreement (SA) as they provide the governing and legal framework for your investment into the deal. Make sure that your understanding of the terms of the deal as represented in the investment deck is clearly spelled in these documents.
Break of Day Capital created a free evaluation tool with a comprehensive list of questions that you can use when evaluating the sponsor team. https://breakofdaycapital.com/investor-tools/
As always, please feel free to reach out to Joe if you have any questions. firstname.lastname@example.org