In this business we call syndication, it is necessary to have a better understanding of what underwriting is all about. Rob Beardsley, co-founder of Lone Star Capital Group, started doing syndication two years ago and is an expert in underwriting. He talks about underwriting and the key fundamentals people needs to know about it. Rob describes underwriting as a submarket of a market and can be partially considered homing in on the details of the deal itself. Moreover, Rob differentiates underwriting from a passive investor and sponsor perspective. Learn more from Rob as he dives into underwriting, what drives a deal, what questions to ask, and what you should be looking for in terms of making a viable investment.
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The Fundamentals Of Underwriting with Rob Beardsley
Our guest is Rob Beardsley. Thanks for being on the show, Rob.
It was a pleasure to meet Rob in Denver. I’ve heard lots about Rob before we actually met and his expertise in underwriting specifically. It’s such a crucial area to have a great understanding of this business that we call syndication and whether you’re active or passive. It’s important that you understand the underwriting or at least you know what questions to ask and what you should be looking for. He’s going to help us understand that. He has a background in business and computer science from Carnegie Mellon University. He leads the underwriting and structuring function for the Lone Star Capital Group.
Prior to cofounding Lone Star, Rob had extensive real estate experience to his family, numerous real estate businesses including development, construction, sales and investment. Rob also actively publishes articles and white papers about real estate, capital markets, family strategy, multifamily strategy and deal structuring. Rob, thanks again for being on the show. It’s a pleasure to meet you. Give the audience a few more details about your background and let’s jump in to the underwriting.
A little bit more about me and my background. I started in the syndication business in 2017 and took to the underwriting, the numbers aspect and what drives a deal. Some say we’re towards the end of which I agree with, a strong bull market in multifamily valuation as well as income growth. That has made underwriting less important because people have been able to buy deals. Whatever mistakes they may have made in the underwriting was pretty much washed away by this very strong market. To add on to that, at the end of the day when you are in the syndication business, you are investing in people and not deals. However, the deals are very important. The number of driving the deals is what makes a viable investment.
You are talking investing in people and not the deals because the operator is key. It can be the best deal you’ve ever seen, but if the operator has no clue or isn’t going to perform, then pretty soon it’s going to be the worst deal you’ve ever seen.
You can pretty much simplify it down to what’s the deal, what’s the market and who’s the operator? You can partially consider underwriting basically homing in on the details of the deal itself in the sub market and the market. You can’t put numbers on trust and people but underwriting takes care of half the page.
I wanted to clarify, even the term like you said, end of a bull market. If somebody says bull market, what does that mean?
A bull market is referring to the stock market. Stocks going up, bull market. Stocks going down, bear market. Even more specifically for multifamily, since the great recession, we’ve seen a huge compression in cap rates, which is how multifamily is valued. Even if the income on the property, it doesn’t change at all. You bought it, sat on it, you collected the same rents, you had the same expenses, but your cap rate compressed because of various factors such as interest rates or investor demand. Your property could have doubled in value. People realistically saw that happened to their properties without renovating, without improvement management. That’s not the only thing that happened. The other thing that happened is we’re having a very strong demographic tailwind of increased renter demand, household growth, income growth. That has led to not only have cap rates compressed, which bull valuations, but also NOI growth. Net Operating Income has grown significantly over the last ten years, consistently year-over-year. Those two things resulted in a huge drive in total valuation.
Let’s get into the underwriting and some key fundamentals that everyone that’s getting into this space needs to know. Get us started.
[bctt tweet=”Hopefully, you trust your sponsor to provide you honest, transparent rent comps.” via=”no”]
We’ll start from the passive investor LP perspective and then work our way up to approaching underwriting from a GP or sponsor perspective. Starting it as a passive investor, being at least knowing the key factors or some of the key indicators that drive the underwriting is helpful, when evaluating a deal. I see a lot of the investors making their investment decisions solely based on who the sponsor is, which is very important. Reading over their glossy offering memorandum and that’s pretty much it for them. There should be an added layer of due diligence, which is digging into the numbers. Not only accepting those numbers at face value, but actually assessing the validity or the viability of those numbers. Starting with the simplest measures are cap rate, and it’s cliché because that’s the first thing you hear and the most talked about number. However, the cap rate’s not a cap rate.
There are a million different ways to value a property’s income. It can be misconstrued to appear better. Some of the ways that I would encourage investors looking into a deal’s historical calculator is first, I would make sure that the numbers you’re looking at are truly historical. Nothing is being projected out into the future that these numbers actually happened in the past. Going from there, it’s most likely necessary to tax adjust the historical financials. Typically when you purchase property, the taxes will be reassessed, especially if you’re buying value ad and putting CapEx dollars into the property because the assessor’s office is going to see that. They’re going to see that you’re going to be driving income through raising rents, renovations and they’re going to want to get their piece as well. Look to a larger assessment at that point. It’s helpful.
We’re talking about as a passive investor some things to look out for the underwriting, but making sure the numbers look right or are truly historical, how do I know that as a passive investor? What are some of the things I need to be looking at or asking? Maybe that’s even intimidating to me as a passive investor. I’ve got this other business I’m an expert in, but I want to invest it in some real estate. How do I know how to do that?
That goes back to who you’re investing in. Hopefully, your sponsor is doing a good job in reporting the numbers and showing you a simple breakdown, “Here’s our T-12 analysis or here’s the historical P&L and then here are year one, pro forma P&L and year two, year three and year four.” Making a clear distinction of, “Here’s the numbers as they are, here’s our plan to take them there or take them where we want to go.” It’s not uncommon that people are pushing the numbers to make deals look similarly attractive as they have been years ago with how the market’s performed amazingly. It’s not uncommon to see sponsors have a 20%, 30%, 40% increase in their income from historical to year one. That definitely needs to be substantiated to say the least. Starting with asking if it’s unclear as to what the cap rate or what the financials that they are referring to. If you want to get to the core of it, you should ask for the due diligence files that the sponsors themselves are using it to underwrite and put together the business plan. That would be the seller’s T-12 and the seller’s rent roll.
That’s the first thing I do off the bat because cap rates can look decent a lot of the times before you adjust for taxes, especially for older properties that have a very low assessment. You can be looking at a six and a half cap and it’s a value-add deal. However, if the property tax is let’s say $200,000, but you can reasonably assume a 25% increase to the taxes, you should factor that into your cap rate to see how much income you are actually purchasing for your dollars. The next adjustment I like to do is management adjustment. There are a million different ways to manage a property and there are a million different compensation structures.
Some owners don’t have a management fee included in their financials at all and some have a very bloated fee structure. I would like to first of all, identify all the items in the financials that relate to a management fee, throw them all out and then plug in what it would cost us to manage it. Put that into the historical financials. We’ve adjusted the historical in place numbers with what we think taxes will be moving forward, as well as the cost for us to manage. We don’t care how much it costs to them, how much it costs us. We’ve pretty much figured out the true level of income or purchasing, how much income I’m buying for dollar.
“What’s my income per dollar?” I like that.
We went a little deep there especially for a passive investor, but that’s a great place to start. Looking over another group’s underwriting from a passive investor’s perspective. What’s the year-over-year change in NOI from T-12 to year one, year one to year two, three, four, five especially if you’re looking at a ten-year deal where the sponsors underwritten on a ten-year timeline. I would be very cautious if I see that the sponsorship is showing that income is going to be increasing year over year by 3% to 5% even out in six, seven, eight, year nine and ten because that’s a lot of years of assumed more positive growth.
What would be a safe range that we should be looking for there as a passive investor where you would say, “This looks like a conservative deal or maybe underwritten conservatively enough that I feel comfortable investing as far as the growth that should be expected.” I know the location, the market, all those things play into that. As a passive investor, what should I be looking for?
2% year-over-year growth after the business plan has been achieved. There are two forms of growth that you have to model out into a value-add deal, which is first the growth that you’re affecting on the property through forced appreciation, spending money, improving management in order to increase rents and decrease expenses. That usually occurs in years one, two and potentially three. After that property should stabilize out and there shouldn’t really be any outsized growth embedded into the underwriting. Some of these very fast-growing markets may continue to grow quickly at 60%, 70% rent growth per year.
[bctt tweet=”If we never catch up, we will never make money.” via=”no”]
All these markets that are experiencing that level of growth, nobody was underwriting years ago. We’re going to have 7% rank growth year. Nobody knew, maybe they thought that was a good market, but they probably underwrote conservatively to a 2% or 2.5% rent growth and a 15% IRR. The market took off and they have a bonanza. You don’t want a sponsor relying on another terrific run of rents and cap rate compression to achieve their returns. I would say after the business plan has been achieved, look for a stabilized growth in income of 2%.
If 2% after the business plan’s been achieved, then you’re going to consider that conservative underwriting.
Then the next piece we’ve covered in place numbers, growth and now the exit. We’re starting from most difficult to misconstrue, the least difficult. It’s pretty hard to say my year one numbers are going to look this way because they’re grounded by the current numbers. The further away you get from the current numbers, there’s more that you can argue and play with and say, “Give us five years and the property will be in this sort of shape with these sorts of rents.” Similarly, your exit is very disputable. You could say, “I think the market will be better than now or prices will soften.” The way that you control the exit price is through the exit cap rate. Typically, you hear a lot of people say, “We model a conservative exit of 50 or 100 basis points above our entry cap rate.” That makes a lot of sense because if today you have to pay, let’s say a five cap for the product you’re buying, theoretically, the market could be in a reasonably worse place to sell that same property at a six cap.
That is conservative underwriting. However, what a lot of people are missing is, let’s say for example, I’m buying a hundred unit building but it’s only 50% occupied and because of that low occupancy, I’m paying a three cap. If it were fully occupied it would be a six cap, but I’m paying a three cap because I’m buying less income and I’m essentially paying more money for the opportunity to lease that building up. It would be extremely aggressive and simply incorrect for me to assume I can exit that deal at a four cap because I bought it for three. I go up 100 basis points and I exited the four because the market is a six for that product when it stabilized. You have to make sure that you’re modeling up on sale what actually the above 50 to 100 basis points above what the current market cap rate is for that sort of product, not value-add the stable but stable to stable.
I hear some people say, “I don’t really care about cap rate especially when I buy a property.” What are your thoughts about that?
There’s something to be said about that because it’s not the end all be all and not everybody is looking for yield. Some people are comfortable with buying a property with a lower cap rate or the embedded growth. If you look at New York City, Silicon Valley and Los Angeles, if you look at key markets, core markets like that, they have the lowest cap rates. As a consensus in the investment community, people believe that those markets will grow faster and be more resistant to the negative effects of the downturn. That’s why they’re willing to pay that premium potentially at a lower cap rate for those markets. However, during your ownership period, you’re going to get much lower cashflows than otherwise available in more reasonably priced markets. I don’t want to say cap rates don’t matter, it’s just you certainly don’t need to buy a certain cap rate to make a deal a good deal. A deal can be a good deal at any cap rate. It depends on the business plan and what you’re looking for, whether you’re looking to getting your return to be a yield or a per capital appreciation.
The cap rate doesn’t mean everything or it’s not to take all or whatever. Then elaborate a little bit on what you say 50 basis points or 100 basis point. I know that’s a term we use in the industry a lot. We’re talking about underwriting. For somebody that’s just learning this, what does that mean?
One hundred ten basis points is equivalent to 1%. When we say 50 basis points, it’s half a percent. When we’re discussing certain metrics, the number needs to be so precise that it’s easier to refer to basis points. You’re talking about ten basis points is just 0.1%.
As far as talking to your investors and things like that, how often are you using terms like that when talking to somebody that’s looking to invest in a deal?
As you can tell, it’s hard for me to filter myself. I get into it and getting excited saying all the terms. I pretty much speak this way as I would to a peer investor. I encourage people to stop me and ask questions. I hope they are asking questions.
[bctt tweet=”At the end of the day, we’re in this business to make money.” via=”no”]
We are talking about the exit plan, the exit cap rate. Keep going.
We started at where are we in place numbers, what’s the projected growth? Then what are the assumptions upon exit? That are the three foundations of conservative underwriting. At the end of the day, you can tweak a deal by saying, “If we assume we’ll sell it for a little bit more, then the numbers will look all that much better,” or, “If we assume a little bit more growth than years three, four and five, it will sell at a higher price as well as having higher income during those years because the sales price is calculated based on the final year’s net operating income.” When you manipulate income, not only are you assuming more income coming in during the ownership, but you’re also assuming a higher exit price because of that increased income. I would say we pretty much made it from there. If there is a strong story that involves rental increases, as a passive investor it would make sense to review the cost. Hopefully, you trust your sponsor to provide you honest, transparent rent comps. You can say, “There’s a community down the street that’s achieving $1.25 grants. We’re only at $1.10. They have a $5,000 renovation in place. If we do that, it makes sense that we can achieve that as well.” Rent comps is a feasibility test to the business plan.
What about moving into the sponsor side, maybe some other things? Let’s dig into the weeds a little more as far as the underwriting and helping somebody that’s maybe looking at a deal now or underwriting something now, they’re looking to pursue through syndication.
Moving to the GP side, I’ll take a step back and look at it from a perspective. You’re looking at a deal, you’re looking to put in an offer or formulate a business plan. There are so many ways you can go. You can pursue a deal with permanent financing, bridge debt. You can tweak with your GP performance splits as far as your fees and you promote. There are so many ways you can structure a deal and to hopefully make it a better deal for all parties involved. As far as the GP, it’s important too when you’re looking at a deal, the debt is a major component of the deal. It’s worthwhile to evaluate your options when it comes to debt. Typically, your options are the agencies like Fannie Mae and Freddie Mac, and then the whole bridge world. Then there’s also HUD.
I would encourage everyone to look at all the options and get educated on the different ways that they could potentially match up well with a business plan. You might have seen my article about the case for floating rate debt. Floating rate debt is a very interesting product right now. As of now there’s a 20% probability that the fed will lower rates this 2019. In 2018, there was a huge bias to the upside or to the increase in interest rates. Everybody want fixed rate debt but a lot of people overlook the steep prepayment penalties associated with fixed rate debt because people were looking to lock in the lowest fixed rates possible for the longest term possible because they were scared of one, a recession and two, for rates going through the roof.
In order to get the lowest fixed rate, you’d have to accept really a draconian prepayment penalty, which would be yield maintenance. Meanwhile, for floating rate debt, it’s just a 1% exit fee. It’s pretty much the cheapest thing that you can get. If you believe historical numbers, the benefits of an overall lower cost of debt payment for floating rate debt. That’s some of the more complex things to look at as far as underwriting. Should you use fixed rate debt, floating rate debt? That depends on where do you think the risk lies in your deal? How long do you plan on holding the property? Also, there are a lot of ways to balance a business plan versus investor expectations. Maybe it’s easier to raise capital with a fixed rate loan as you can pitch it to investors, “We’re buying a fixed rate. We’re buying a property with a long-term fixed rate debt. This is safe. This is conservative.” Even though, which I’ll say in my opinion, I think the floating rate option may be better right now.
You’re going to have to be able to explain that to an investor and you did just then. I really like that. It’s obvious you have to understand the debt and you have to understand your exit plan so you know what type of debt you should obtain.
That just goes into the underwriting. If you are going to use a long-term fixed rate loan product with a yield maintenance prepayment penalty, how are you going to model that? Typically, most deals are underwritten on a five-year term, but if you’re doing ten-year debt with yield maintenance with five years halfway into the loan, that could be 6% equivalent prepayment penalty, which really wouldn’t preclude a free and clear sale. It would force you to sell as an assumption and assumptions are at the end of the world. If you are underwriting, it’s assuming a large increase in your purchase price and your sales price. Now you’re selling your property and your loan to the next buyer, but your buyer is interested in your loan because you’ve sold it the price at a much higher level. The loan is a much lower loan-to-value ratio and that means the borrower is going to pursue a supplemental alone. Supplemental loans are typically a bit more expensive and not as flexible. It’s important to assess, “What is my exit strategy and how viable is that? Maybe I should discount my exit cap, meaning I should discount my projected purchase price to more realistically accommodate an assumption sale.”
I want to get to a couple more points on the act of GP side after financing.
In terms of GP structure, this is more of a personal question or answered internally for GPs, but what kind of fee structure would you like to charge? The half of the conversation is we need to make sure that our interests are aligned with LPs. Our passive investors think that our fee structure is reasonable and incentivizes us to do the best job possible for them. Then also at the end of the day, we’re in this business to make money. How can we put into the structure in place that in our opinion benefits the investors as well and still make sure we get paid? There is a discussion thereof we need the right balance of fees and then performance-based fees. A lot of the GPs are looking at putting preps on their deals or not having a preferred return. The preferred return is just when the LPs and the passive investors, they get not necessarily a guarantee but the first 8% of the profits coming out of the property every year are owed to the investors. Thereafter, once that hurdle is met on an accrued basis, then the GPs get together a piece of those ongoing profits. There are arguments to be made both ways.
A lot of sponsors are removing the prep because number one, it’s so difficult to hit these days. Getting a property to realistically achieve 8% cash-on-cash in year one of a value-add plan is very tough whether you’re doing a bridge loan or permanent debt. A lot of sponsors are saying, “It’s so hard for us to hit our prep. We’re going to get behind in year one because we were only going to return fire. If we will never catch up, we’ll never make money. Let’s just not have a prep.” They’re selling not having a prep by saying, “A prep doesn’t align our interests because what it incentivizes us to do is to take on more leverage, take on more risks and try to achieve lots of cashflow or it incentivizes us to sell because we know we’ll never catch it to prep. We’ll sell a perfectly good asset just so that we can get a piece of the capital gain.”
All those things are true. However, if you look at split on a mathematical basis saying if you have normally an 8% prep with a 70/30 split on the back in favor of investors, versus an 80/20 straight split. The 80/20 straight split is extremely expensive. Investors looking to place their capital with sponsors should insist on a prep not only because it’s the fairer way. Really in these days with cash-on-cash being so low, they’re going to do so well because they’re going to get pretty much all of the cashflow. Most of the deals we’re doing, we’re anticipating giving 95% of the cashflow to investors just because we frankly are having a hard time finding deals that will adequately hit our prep.
I appreciate you bringing that up as far as they should insist on a preferred return and how some teams are not even doing a preferred return. I would ask this to you because it’s a question I’ve heard numerous people talk about in the industry. I’d love to have your opinion as far as raising the capital ahead of time to meet the preferred return in year one. Let’s say we’re expecting a bit of vacancy and obviously there won’t be the cashflow there to make the 8% preferred return. What about raising that capital ahead of time?
There are a couple of ways you can go about it. If you’re upfront with investors about the mechanism with which you are delivering that preferred return, that makes the joke of, “You’re buying a five-cap. Your cost of debt is a five cap. You have no positive arbitrage between your income and your debt. Yet, in year one you have an 8% preferred return that you’re meeting. It doesn’t make sense.” If you’re upfront with your investors as to how you’re magically meeting your preferred return and they’re okay with it, then by all means. In my opinion, I think it does a couple of things that are negative to the deal. Number one, by having to raise that additional cash, it weighs down the deal. It increases the nominal prep amount and it actually will lower the IRR because there’s more money that the profits have to be distributed to.
The other thing is, and this is really why GPs do it, is by quickly meeting the prep via simply raise cash distributions. Now the GPs have met the prep and they can start collecting a percentage of the cashflow. They’ve artificially met the prep and they’re able to participate in the promote or the cash-on-cash performance of the property via that mechanism. Other people are struggling, let’s say 5% in year one, then in year two, maybe they’ve done a good job and now they’re an eight. They still owe that 3% from last year. Then in year three, they do even better there at ten. It’s still a 1% from year one. They’re not going to get paid until maybe year four based on the promote split or the performance, etc. That can seem extremely unattractive from your GPs perspective but from an LP, that’s great. As a passive investor, I would rather not see raise capital be distributed to meet the prep.
There are so many more questions I want to ask and I hope to have you back on and discuss this a little more in detail on a few other topics around underwriting and other things. Tell the audience how you learned how to underwrite deals and become so educated in this topic and then also tell them how they can get in touch with you.
When I first got into the business, this is where I gravitated to. I started out just googling all the cashflow models, the underwriting models. I said, “I need to underwrite deals, so let me find myself a model.” My dad and I at that time we’re working on joining the business together. He said, “Nope, you’re going to build your own.” I said, “Why? That’s such a waste of time. I can just download a perfectly good one. Why do I have to recreate the wheel?” He said, “You’re going to build one and it will be better than all the rest.” I can’t say it’s better than all the rest, but I will say that I’ve spent over 100 hours building it and iterating it. Through that process of building my own model, I’ve just learned so much. I have a finished product with which I can live and breathe with and trust that I’m performing a good valuation. Then just other learning is just reading all the books and looking at crash courses for financial modeling and taking some pages from the private equity cashflow valuation practices.
I would say by building that model, you understand where the numbers are coming from better than a lot of people because you had to build it, you had to tell it to take it from here and put it there and how much and all those things. How does the audience learn more about you and your company?
You can visit our website at LoneStarCapGroup.com. You can email me at Rob@LoneStarCapGroup.com. Shoot me an email if you’d like a free copy of my underwriting model or have any further questions. I’m happy to answer.
Giving out his underwriting that he spent hundreds of hours, that’s a big gift. I hope the audience will reach out to him. I’m going to reach out to him myself so I can get a copy of it. Rob, thank you so much for your time. Your expertise and providing to underwriting is such an important topic. I hope the audience will reach out to you. I would also hope the audience would go to Life Bridge Capital and connect with me where you can also see the podcast and you can search guests and different topics and learn the topics that you need to know right away. Also go to the Facebook group, The Real Estate Syndication Show so we can all learn from experts like Rob and grow our business together. We will talk to each of you soon. Thanks, Rob.
Thanks for having me on the show.
- Rob Beardsley
- Lone Star Capital Group
- The Real Estate Syndication Show – Facebook
About Rob Beardsley
With a background in business and computer science from Carnegie Mellon University, Rob leads the underwriting and structuring function for Lone Star Capital Group.
Prior to co-founding Lone Star, Rob had extensive real estate experience through his family’s numerous real estate businesses including development, construction, sales, and investment.
Rob also actively publishes articles and whitepapers about real estate capital markets, multifamily strategy and deal structuring.