Cap Rates, Due Diligence, & More

release edition [008]

read time [6 minutes]

Welcome to The Multifamily Download, a weekly newsletter where I provide institutional insights to help you build an exceptional career in Real Estate.

Today at a Glance:

Refinance: 180 Days Later
Due Diligence: 10 Observations
Cap Rates: The Hidden Truth
Weekly Listen: BMC Talks S2:E2

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Refinance

We acquired a property in September of 2021 from a public REIT.

Since then, we have executed our business plan and the Net Operating Income has grown by 55%.

Despite a strong execution of the business plan, the Capital Markets have been a major headwind.

Nearly 180 days ago, in August of 2024, we began to size the property for a refinance to payoff our bridge loan.

Fortunately, we were only moderately leveraged (~65% LTC), so we felt good about the opportunity to execute a cash-out refinance.

Then, in September of 2024, the Fed cut 50bps, and the Bond market began it's massive selloff.

Despite the Fed's best efforts to position a strong economy heading into the election, the market didn't buy it, and the 5-year UST went from 3.49% to 4.39% (+90bps) by the end of 2024.

Thankfully, because of our business plan execution, strong stabilized debt yield, and consistent communication, our existing lender gave us a 90-day loan extension through year-end to see how the Capital Markets would unfold.

Unfortunately, they didn't improve. To make matters worse, our initial cash-out refinance quickly became a material cash-in refinance if we elected to go the Agency route.

So, we pivoted back to our existing lender to request another 9-month extension.

The only problem? This particular bank balance sheet lender has been dealing with troubled Office assets on its books and needed to be paid back.

So, we requested and were granted a second extension of 30-days to re-engage an Agency refinance option.

Fortunately, property operations improved post-Holidays, so our loan dollars increased favorably as EGI steadily climbed.

Then, after a third extension of another 30-days, we were in a position to rate lock in a cash-out position.

I share this story for one reason: The Multifamily business is tough, especially right now.

There are countless variables, many of which are out of our control.

Knowing this, our focus throughout this refinance process was simple: Control what we can control.

Our message to our property management team was simple: Push for occupancy, over communicate to residents to maximize collections, and proactively request lease renewals.

After 6 months of sizing, re-sizing, multiple extensions, and meticulous asset management, we achieved our goal: An Agency cash-out refinance.

Due Diligence

In addition to the refinance above, we are under contract to acquire a property in a new market.

I have the opportunity to oversee our firm's due diligence efforts. This process requires careful attention to detail, especially when entering a new market.

Below are 10 observations that I've made during our due diligence process. I hope you find them helpful.

1. Nothing Is Static

Properties are dynamic and ever-changing, and that's okay. Debt and Equity partners realize this, and even expect it. The key to staying calm in the chaos is clear communication.

2. Trust, But Verify

Carefully consider the incentives of all parties involved in the transaction. The Seller wants the Buyer to close. So does the 3rd party property manager, the Insurance broker, the debt broker, the general contractor - you get the idea.

3. Here to There

Every owner's property operations are different, so it's important to understand how the property will be taken from it's current state to the desired future state. Creating a post-close action plan before closing is critical.

4. Online Reviews

Understanding a property's online persona is important. If it's less than stellar, consider working with a reputation management provider that can help enhance the online footprint of the property. Also, ask Google to remove previous reviews once the property is purchased. It doesn't work every time, but it does work sometimes, so give it a shot.

5. Learn The Story

Figure out how and why operations are trending in their current direction. If the property is operating smoothly and positively, why? If the property is fighting to maintain occupancy and collections, why? Understanding the property's trend is critical.

6. Pound the Pavement

Professional investors tour properties. There is simply no other way to say it. This is why I'll be flying to the market and spending 48 hours on the ground to tour the subject property with property management, current management, a capital projects team, and equity partners, as well as touring the market comps and nearby areas. Due diligence requires diligence.

7. Review the Reports

Due diligence reports are great, but it's important to actually spend time studying them. For example, by reviewing our due diligence reports, I learned that the carport parking spots don't have wheel stops, that the property doesn't own its own set of work tools, and that there is no forced placement of renter's insurance if a renter doesn't have it or get it. The details matter.

8. Ask More Questions

Sometimes asking a simple question can open up dialogue that solves a separate problem. For example, our property management company suggested that we add a dog park, so I asked why, and they shared that residents currently have to load up their pets in their cars to go to a nearby park since the property doesn't have a dog park. Simple question, profound answer.

9. Question Every Assumption

It's easy to accept things as they are, but that's not how the game should be played. For example, we received insurance quotes and I setup a conference call with the insurance brokers. Upon further exploration, I learned that one of the key variables was being underwritten in a punitive manner. If adjusted in our favor, property insurance premiums may be reduced by 10-15% and the overall premiums reduced by 7-10%.

10. Consider Every Outcome

Every business plan is expected to go smoothly, but what happens if it doesn't? Many investors wear rosy colored glasses every day of the week and twice on Sundays, but that's not reality. Quantifying the downside will reveal true risks. For example, this property is under contract 30% below current replacement cost, so even though it's in a 'business friendly' market, it is highly unlikely that we'll face supply risk during our hold period.

Due Diligence is a laborious process, but it should be carefully conducted in order to be positioned for success at closing.

P.S. if it makes you feel any better, I've heard stories from sales brokers about a top 30 Multifamily owner that shows up to conduct due diligence with one person holding a legal pad, and that's it. One site visit, by one person, and then they close escrow. (I'll let you guess the owner).

Cap Rates

Cap Rates are a common metric in the industry, but they are perhaps the most misleading one.

Many times, sales brokers aggressively represent incomes and thin out expenses during the marketing process, and then plug in the buyer's real numbers when announcing a 'below market cap rate' sale.

For context, the Cap Rate ("Capitalization Rate") is essentially an inverse P/E ratio, and it is a way for comparing sales across a market.

Two quick examples:

$1M NOI / 5.00% Cap rate = $20.0M value
$1M NOI / 6.00% Cap rate = $16.7M value

The hidden truth about Cap Rates is that they are not the most important metric to institutional buyers.

If NOI can be grown materially then buyers can pay a below-market cap rate.

If NOI cannot be grown materially then buyers will want an above-market cap rate.

To put it simply, buying Multifamily properties is all about simultaneously (1) protecting downside (cost basis) and (2) unlocking upside (NOI growth).

In 2021 and 2022, buyers were buying properties at 3.5% cap rates because they assumed they could stabilize at a 5.5% in-place cap rate and then make their money by selling the remaining value-add story to the next buyer at 4.5% cap rate.

Unfortunately, this 100bps of positive spread (5.5% stabilized cap rate less the 4.5% market cap rate = 100bps) proved to be an insufficient margin of safety when the Fed Funds rate went from 10bps to 5.25% and the 10-yr Treasury went from 2.1% to 4.5% between March 2022 and late 2024.

This shock to the capital markets halted capital flows, and cap rates have risen materially as a result.

Because of this, institutional buyers today are far more focused on yield-on-cost and cash flow than cap rate.

If a higher percentage of the total returns are produced from cash flow then the likelihood of success increases.

Which property would you rather invest in?

Property A: 3% average cash on cash, 4.5% exit cap, 15% net LP IRR
Property B: 6% average cash on cash, 6% exit cap, 15% net LP IRR

Same IRRs, but drastically different deal profiles and exit assumptions.

The obvious answer, Property B, is being purchased at a significantly lower price than Property A, and is therefore less sensitive to the exit cap rate dependency at sale.

I could write several newsletters about cap rates, but I'll stop here.

The point is this: Cap rate is not as important as many claim that it is.

Focus on cash flow, yield on cost, total basis, discount to replacement cost, and downside risks.

Weekly Listen

This week's listen is BMC Talks Season 2 Episode 2 hosted by Alexander Alemany and featuring the founder of ConAm, Daniel J. Epstein.

Under Daniel's direction, ConAm has grown to be among the top apartment management/ownership firms in the United States. ConAm presently manages more than 60,000 apartments throughout the United States valued at over $7 billion and has developed and constructed in excess of 35,000 units since its founding in 1975.

You can listen to the full episode here.