Why do private real estate investors prefer to pursue single deals instead of allocating to a diversified private real estate fund? People have faith in their capacity to select the finest real estate investments because they are already familiar with the market and its underlying fundamentals (we all own homes and use real estate for employment and consumption, after all).
There is a catch here.
A person’s familiarity with home ownership is no guarantee that they can spot lucrative real estate investments. Investors can sidestep this pitfall by putting their money into professionally managed real estate funds or learning the ins and outs of evaluating a real estate investment.
Every single real estate investment that enters Origin’s private real estate funds is analyzed using financial models. If you’re an investor who would prefer not to put your money in a fund, you should learn about financial modeling or hire consultants who do. A complete evaluation, however, necessitates familiarity with such market details as rental rates, the property’s asking price concerning its peer set, demand drivers and constraints on their capacity to increase rents, and the expected selling price.
Due to its complexity, the financial modeling process often leads investors to look at a purchase through only one prism. They may zero in on homes with rents that are comparable to others on the market or sales that are taking place at comparable prices. Another potential buyer would compare the asking price to the estimated replacement cost per square foot. Alternatively, the capitalization rate of the building at the time of acquisition and sale is of interest to some investors.
Though individually beneficial, combining these strategies yields optimal results.
The post-acquisition business plan for the property should also be examined and justified for each component. Revenue and profit expansion post-acquisition is a core tenet of any real estate, VC, or private equity plan. If growth is assumed, how much is it, and how will it be obtained? Inputs that can defend are crucial.
When considering a real estate investment for our capital at Origin, they don’t only look at the numbers. Each input to their financial models is likewise subjected to a stress test, and the resulting impact on the investment is quantified. Recognizing that all business plan assumptions may not be perfect, they seek to quantify the impact that subpar performance on a critical input will have on the overall return on investment. Investors in funds should expect the same degree of care from those in charge of their money.
Test #1: Business Strategy for Initial Product Development
We will share the numbers from a recent stress test we ran on a Denver asset to give investors an idea of what a stress test would entail. While we prefer value-add investments, we will consider ground-up development and other opportunistic investments if the potential rewards seem excessive compared to the associated risk. Because it allows them to highlight a broader range of model parameters, we’ve settled on development as my case study. We’ll walk you through the possible investment inputs and explain how and why we arrived at the stress testing level we did.
A. Base Case Column:
The base case column displays the estimated base case assumptions and returns for a five-year hold period. Assuming an 18-month development period, a 15-month lease term, and a 5.75 percent capitalization rate on rents in year five, the model predicts a sale price of $306 per square foot.
B. 0% Rent Growth Column:
Financial forecasts for the private sector typically count on rising profits. Investors’ primary concern should be whether or not it can sustain this growth rate. Our projections indicate that rents will increase by 2.5% per year during the hold period of 5 years. It is based on our familiarity with the market and data from two licensed submarket and property-level databases.
Submarket rent growth has averaged 7% annually, while occupancy rates for multifamily assets have averaged 95.6% over the past four years. We anticipate high demand for local housing due to the expansion of the Denver airport and the construction of an Amazon fulfillment center close to our development. Last but not least, the Denver light rail, another demand generator, is now operational, connecting our property to the rest of Denver and the airport. Based on this data, Origin concluded that a rent growth of zero percent was a real stress test for the model.
C. 20-Month Construction Column:
On a level plot of ground, the Origin is constructing a garden city. All necessary infrastructure, such as utilities and roads, as well as construction blueprints and permits, have already been completed. The business plan’s general contractor spent 12 months constructing a similar residential complex in Salt Lake. The stress test estimates an additional two months of building time beyond what is assumed in Origin’s base case business model (18 total). It may seem like a safe buffer, but as the economy has improved, there has been an availability decrease of subcontractors, which has caused construction times to increase.
D. 8-Month Lease-Up Column:
Once construction is finished, our baseline scenario predicts that it will take 15 months to fill the building with renters. During this period, we anticipate that demand will surpass supply during the next 24 months because we’ve seen comparable buildings take 12-15 months to fill with renters. The business strategy anticipates deliveries to start around the tenth month (January 2019) and run through the fall of that year. If it takes them longer than 15 months to rent out the units, the stress test increases the base case assumption by 20%.
E. 10% Lower Starting Rents Column:
An initial rent assumption is used to calculate rent increases in all models. The returns will be lower if the rent is lower than anticipated. Origin first reduces this development risk by presuming we will lease up the building’s units at market rentals. This method, which they refer to as an “untrended” rent model, gives them the market growth rate for the year they build the flats, giving them a nice cushion. For the stress test, rents are set ten percent lower than the going rate for some time between ten and fifteen months into the future. They are not increasing rents as the market data shows they should work during construction; instead, they are assuming a 10% decrease in rates. In the past, this has been quite improbable, especially in Denver.
F. 20% Hard Cost Overrun Column:
To determine the overall budget for the project, Origin consults with the contractor. A more precise estimate of costs can be made the closer the plans are to completion. Our sample model was based on a general maximum price (GMP) agreement between the client and the general contractor, which permits cost overruns only for appropriately sanctioned changes to the project’s scope. The general contractor accepts all responsibility for completing the project within the agreed-upon quality, cost, and schedule parameters. In addition, Origin felt confident in the defined scope of work and quality of finishes thanks to the 99 percent complete plan to bid on the GMP contract. They have faith in the General Contractor’s ability to complete the project on time and under budget because he has completed a similar project in the past. As an added safety measure, Origin includes a 4% construction contingency in the project budget to cover unforeseen costs. Given the preceding stages, it is reasonable for us to employ a 20% overrun in our stress test on construction cost overruns.
G. 5% Higher GVAC (Vacancy at Sale Assumption) Column:
They make a best-guess prediction of how complete the building will be when it goes up for sale. According to our research, the occupancy rate in our project’s area has been consistently high over the past four years. Projections for supply and demand indicate that occupancy rates in the submarket will rise to around 95% shortly. The high demand for rental space is reflected in Origin’s other holdings in the area. As a stress test, they double the market’s vacancy rate from 5% to 10% with the hold and sale strategy.
H. High-Stress Column:
The final column synthesizes these tensions. Many of them do not correlate, so it is unlikely they would all co-occur. For instance, if rents are falling during a recession, construction expenses are unlikely to rise simultaneously.
However, if every possible stressor materializes at once, our equity multiple falls from 2.6 to 1.4. As a result, an investor who puts in $1 million will still get a profit of $1.4 million. This stress test has resulted in a 25 percent decrease in the exit price per square foot, from $306 to $228. Because of the combined stress test results, Origin is confident its investment will continue to generate a profit even if they face severe challenges.
Test #2: Earnings Multiple for New Construction
They also put their predicted multiple on earnings through its paces, just like we would the business strategy for a project, to ensure it can withstand adverse conditions. The capitalization rate determines a multiple on the property’s net operating income in the year of the sale, making it an essential part of any real estate transaction. You can use this method to determine the selling price in the year.
The capitalization rate and price per square foot methodology must justify the sale price of assets in the base case model for investors. There better be a compelling justification for paying more than what it would cost to replace the sold item. Reasonable causes include the ever-increasing price of construction, the impossibility of constructing owing to zoning restrictions, and the presence of some indispensable quality in the structure that will provide a long-term competitive advantage.
Origin uses a capitalization rate of 5.75 percent in our base case scenario. The 10% rise in our exit capitalization rate is baked into the investors’ base case scenario. The increment is implemented linearly at a rate of 2% per year. Since this rate is set by investors’ risk tolerance, the risk-free interest rate, inflation expectations, and the total amount of capital available to purchase assets, they recommend exercising caution. Although they have complete control over the building’s construction, leasing, and operation, they have very little say over the capital markets when it comes time to sell.
The above matrix, assuming a 10% increase in capitalization rates at the sale, displays our base case returns of 5.75%. Around this median, they model both a positive and negative outcome. If capitalization rates stay the same as they are now during the hold, the calculations result in a gross multiple for investors of 3.0x. Investors would obtain a 2.3x gross multiple over a five-year hold even if cap rates grew by 20%. In other words, even in the worst-case situation, they know that investors will make money on this project.
Do not make the mistake of chasing after isolated property transactions. An investor should have sufficient market knowledge to examine each input assumption and its defensibility, as well as a working knowledge of how to use financial models to comprehend the risks and rewards of an investment before making any investments. In this piece, we go through the steps an investor may take to take this further by stress testing the financial assumptions in the models. Alternatively, you can hire a real estate fund manager to handle your research and analysis.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.