WS588: The Definitive Guide to Underwriting Multifamily with Robert Beardsley

[INTRODUCTION]

[00:00:00] ANNOUNCER: Welcome to The Real Estate Syndication Show. Whether you are a seasoned investor or building a new real estate business, this is the show for you. Whitney Sewell talks to top experts in the business. Our goal is to help you master real estate syndication.

And now your host, Whitney Sewell.

[INTERVIEW]

[0:00:24.1] WS: This is your daily Real Estate Syndication show. I’m your host Whitney Sewell. Today, our guest is Robert Beardsley. Thanks for being on the show, Rob.

[0:00:37.7] RB: Thank you very much.

[0:00:39.1] WS: Rob has quickly become an expert in a topic that’s so important in our industry. The last time we had him on the show it was a very popular show and Ryan hadn’t even told Rob that yet but it was a very popular show and even from what he said, he responded in a great way and because he has become an expert like you said on this topic of underwriting.

It’s a quality that you have to have or somebody on your team has to be really good at underwriting to be successful in this business so I would encourage you to go back and listen to our first show, we talked about underwriting there it’s episode so popular, I knew it was good to have him back. A little about him in case you missed the other show, he oversees acquisitions and capital markets for Lone Star Capital and has identified and negotiated and structured over a hundred million dollars’ worth of multi-family real estate transactions.

He has evaluated thousands of opportunities using proprietary underwriting models. Also helps run Greenoaks Capital, his family’s real estate investment advisory firm. Rob, thank you again for your time and being willing to come on and share your expertise.

Let’s just jump right in or maybe you can give us an update on Lone Star capital and what you all are up to right now but I’d love to just dive in to the underwriting.

[0:01:47.9] RB: Yeah, let’s dive in, like you mentioned in our first episode was also pretty brass tax, we talked about real performance indicators and things that you can really use right away and  use to evaluate and understand deals better and I definitely don’t want to repeat things that we talked about last time, hopefully just have new discussions and new ways to identify value and what not but as far as Lone Star Capital, not much has changed since we spoke, you know, we’re growing in assets under management.

We’re growing in our team, adding more people to help us on the acquisitions side as well as the asset management side and so we’ve got some exciting growth and things coming in the works that I don’t want to quite announce yet but I guess when I say not much has changed, it’s just because I’m looking in my little day to day work and I don’t see the bigger picture often just because I’m working at the task at hand but no, it’s exciting things that are happening.

[0:02:41.1] WS: Nice, well, you know, maybe we should just go ahead and say, you are also publishing a book on this topic exactly and we want to go through a little bit of that today, is that right?

[0:02:52.1] RB: Yeah, that’s right.

[0:02:53.0] WS: Awesome.

[0:02:53.8] RB: Just I mean, to something quickly on that, like we talked before we started recording, so much I get people reaching out saying well, you learned this stuff and you must have read a book or taken a course or watched a video or podcast series and that’s how you learned, right? What are those resources, just shoot me an email and then I’m good to go.

Unfortunately, that’s just not how I learned and not for a lack of effort. I searched for answers and really didn’t find the most straight forward way to learn underwriting and analyzing deals and obviously there are resources out there and there’s also bootcamps and people charging thousands of dollars over weekends or even multiple weekends to learn and I never was able to attend one of these, I’m sure they’re helpful but I’m really excited to be able to now share this book with people that asking you this question and say hey, this is not going to be the end all, be all for you but it’s a great starting point and I think something very digestible, whether you’re just getting started or even pretty advanced.

[0:03:57.1] WS: I know it’s going to be popular because it is such an important topic and it seems like there’s a big mental block for most people when it comes to underwriting and just what you just said, where do I even start, how do I even know what to look at, what should I even ask for, where do I put in all these numbers, what do I even use to figure out this is a good deal or not. Maybe you’d give us a minute or two on how did you learn how to do this, how did you get into underwriting and become very proficient at it.

[0:04:25.4] RB: Yeah, really, spreadsheets and math numbers have always been an interest of mine and I love figuring out how things work, I love the black and white nature of math, rather than the shades of gray of writing, although I’ve learned to love writing and especially about the topic of underwriting.

But I started out just through trial and error and being thrust into it, I was working with my dad on multi-family acquisitions and he was very intent on my learning it myself and building my own underwriting model. He felt that if I went out and learned it on my own and built my own model, I would understand it better which at first I thought it was crazy, I thought it was just way too much work because why would I not just take the existing model out there that somebody already built and just run with that because why would I spend all these extra effort?

But he was actually so right and so many more ways it’s been so helpful to build my own model which helped me learn the basics, learn the underwriting and then actually, be able to evaluate other people’s models and just deals in general.

Of course, that model has iterated over time to become a whole lot better than what it once was and then just like you said earlier, underwriting thousands of deals. You learn so many things and not being afraid to put myself out there so when I was first speaking with brokers, you know, I be kind of scared to provide my feedback and say well, I think this deal’s worth 15 million because what if they laugh at me or think I’m crazy and I’m way off on the value.

Being able to have those conversations and actually support my evaluation and say well, I think the payroll is this and you know, the stabilization timeline should be 18 months versus 12 and kind of support those different things, that’s really helping over time.

[0:06:12.5] WS: Wow, yeah, underwriting thousands of deals, that’s definitely a way rot learn a lot about underwriting. But even going back to the question that I often get too is like, which model do you all use? You use these guys or this guru or all these different models that we can come up with, right?

I’ve heard other people say, well you should build your own and that does seem so daunting. If I had thought, think right now of how I’m building my own, even now, man, that’s going to take me a while, you know? I mean, that is going to take a long time. But you’re definitely going to understand the model a lot better, right?

[0:06:43.5] RB: Yeah, another big benefit of building your own, I don’t want to make this a show about why it’s so great to build your own because it’s not like you said, it’s a huge time commitment and if you’re just starting out, I’d say yeah, it’s a good exercise because it’s almost like a class, right?

If you are running a business and you don’t have time to step away and you know, pull out a white board and kind of brainstorm how you want your model to look and all these stuffs. Maybe under quarantine now you do but in terms of practical application,  it doesn’t always make sense to build your own.

But, one of the benefits of building your own is you know exactly how it works. You can similarly create that same confidence just through using another model and getting comfortable with it and just do repetition. If you take any model, right? Like you mentioned, there’s a guru model or there’s this standard model or this preferred model and if you underwrite one deal through it, you really have no idea if that model then spit out 20% IRR, you say, well is that good, I mean, I know 20% generally is good but for that model is it good and how is it really calculating that IRR’s?

Only once you’ve underwritten. In the book, I said a hundred deals. I think that’s kind of a lot but if you’ve written a hundred deals with the same exact model, you’ll really understand what a 20 IRR means in that model and so what I explain in the book is it’s less about the numbers and more about kind of the bell curve of returns.

If in your model and you’ve been underwriting hundreds of deals through all these deals you were receiving from brokers and most of the time, you get a 10 IRR or 12 IRR and then all of a sudden, 15 pops up. Wow, that really sticks out and then you know, you have a special deal and that 15% IRR may not sound amazing to other people who are using a different model that might have different more aggressive assumptions. But you just have to get to know your model.

[0:08:35.8] WS: Okay, that makes complete sense and I know the listeners are wondering right now, well how’s Rob underwriting deals today, you know? I was just thinking about that and I’m like, I get that question as well, email today from somebody, asking me about what are you all doing right now, how do you even know what the value is, you know? What’s it going to be a month from now. You know, I just thought of that, I know that’s what they’re asking and so why don’t we just jump in to that a little bit and broad value it that way and they’re going to just see how –

That you are an expert in underwriting and love to hear what you’re doing, how you’re underwriting deals right now.

[0:09:07.9] RB: Yeah, today we’re sitting in mid-April 2020, right in the middle of the coronavirus pandemic and the transaction volume has gone way down so we’re seeing much less deal flow than we just a couple of months ago were, right? On top of that, we’re being even more selective with deals that we are even willing to underwrite.

Our universe of deals have significantly shrunk and then our personal universe and deals that we’re willing to seriously consider has shrunk. We’re really underwriting far fewer deals today than before and then in terms of how we’re underwriting them, I’ve gotten this question also like you might imagine a lot as well, the thing that feels the most natural to me in terms of how are you incorporating the uncertainties of the future as well as potential collection loss and in the immediate term and my answer really is to not look at that and focus on that quite as much.

Because, if you’re e underwriting on a five year or a 10 year horizon, this is going to be a small circumstance in your overall business plan. Even more so, so much of returns depending on your business plan are derived from your exit assumptions, right? You may have cash flows ongoing, first  year a little lighter, second year grows and the real driver of returns especially for value ad deals is your exit.

If you’re planning on exiting in five to 10 years, coronavirus is potentially not going to impact you whatsoever. If you have a two year business plan or a three year business plan, I would say, you’d really want to stress that one because that’s obviously much more short term so to answer your question, we’ve been looking at deals on a long term horizon because we want to be able to weather the storm and then you have the debt side of the equation and that’s what’s really been shaken up.

Pretty much  the only game in town right now is Fannie and Freddie and they’re loan terms have varied significantly and they’ve cooled down or they calm down, spread with calm down and it’s become more normalized lending environment but you still have the big reserves which you are potentially aware of. Those reserves are holding back a whole lot of debt proceeds which obviously directly impact your leveraged returns and just often, the debt, having that reserve hold back and having a little lower leverage point because the lenders are going instead of 75% LTV, now 70% LTV.

That right there is knocking potentially 10% off value. If you have a seller that really wants to transact today, just accounting for the debt side, they’re going to lose 10% of value. If you start factoring in a worse economy over the medium term due to coronavirus then that should be another 10%. There’s really a whole ton of uncertainty in valuations and sellers aren’t readily accepting 10% lower value today, right? They can just say well, okay, I’m not going to sell. Just like we are actively buying and selling the market today, we’re choosing not to sell a property that we previously had on the market because the market has changed into this and we’re no longer happy with the terms available in the market, right?

We much rather just continue to own our properties and continue to manage and operate and wait for a better time so it’s going to take a more prolonged situation for sellers to really bring down their pricing assumptions about their own properties so that’s why I don’t think hammering deals super hard on the operational side is really going to do you very much good because the debt side is already doing that for you and the bid to ask spread is just getting wider and you’re not going to get a deal done.

[0:12:46.1] WS: I love that outlook and right away you talked about okay, we’re not going to focus completely on the uncertainty of the next couple of months, we have to think about it and plan for it if we’re closing on something right now of course. However, if you’re doing a seven  year deal, I love how you said seven year hold, 10 year, whatever, this is really minor, it should be really minor anyway in that entire business plan.

Actually, a couple of other things I wanted to elaborate on, just because the debt side is so important. I mean, all the time. But especially at the moment, right? Things have changed so much. You talk about like the spreads coming down, I know we use terms like that all the time but what does that mean to somebody that’s just listening right now?

[0:13:24.7] RB: Good point, an all-in interest rate, if you are going to borrow money for a multi-family investment, from let’s say Fannie Mae and you’ll get all-in interest rate of let’s say, 4%. That all-in interest rate is comprised of an index rate as well as a spread and that spread is a credit spread and that represents the lender’s risk premium that they want to achieve so if a lender is lending on a 10 year term, their index rate or t heir base rate will be the 10 year US treasury yield.

Let’s say that is at 80 bases points, of just .8% and then they’re going to put their spread on top of it and if we’re getting to a 4% loan,, to make the numbers – let’s just say at 1% US treasury and then 3% spread to get you to an all-in interest rate of 4%. When you’re talking about the loan environment, you could have volatility in your index rates, the US treasury yield has gone up and down and really volatile and then on top of that, you can also have volatility in spreads.

That would be the lender’s appetite and demand for making loans. If lenders don’t want to make loans, they’ll just widen out their spreads and make their pricing uncompetitive and discourage borrowing. Similarly, a lot of lenders are competing for business, they’ll compress their spreads which is effectively reducing their own profit because they’re always going to be making profit on top of their base grade, right?

They’re borrowing at an index rate and then making money based on their spread. That’s what we’re talking about when we’re talking about spreads have initially when there was a ton of uncertainty in the market and things really kicked off in the pandemic spreads gapped out over 100 basis points, which is a huge move. It was funny because at the same time as you know when investors flee from risk assets, they might move out of stocks and into bonds, which drives the ten year treasury yield down. So we had a big dollar move in treasury yield but a gap up in spreads and so people thought, “Well the ten years down that’s where I’ll borrow cheaper money.”

But no actually, borrowing cost went up all the way to 5% at one point. So it has been an interesting environment.

[0:15:32.7] WS: Give me a minute or two also on just the reserve hold back you talked about.

[0:15:37.3] RB: So I think this is a genius implementation by the agencies as a way for them to keep on lending in such unsure environments. So rather than them pulling back to such low levels of leverage to really make their financing unattractive or to widen out spreads and make interest rates really high or just decline making loans they have implemented a hold back of reserves that include your property taxes, your insurance, your replacement reserves and of course your interest payments.

And that is a hefty holdback that they’re doing for potentially six to 18 months’ worth of those costs and which can amount up to 10% of a loan amount being held back as initial reserves, which really gives the lender comfort that even if you don’t produce any cash flow because you have very high delinquency and your collections are way down, they will be able to continue to fund the loan out of those held back reserves, which is a good thing for them and it is not necessarily a good thing for you.

Because if you are counting on every last dollar of leverage and you’re only getting – if they are already pulling back leverage from 75% to 70 and now you are getting 10% of that held back in reserves, you are only getting 60% on your value, which just a few short months ago people were being levered up to 80%. The really interesting thing is it is pretty straight forward to talk about the numbers like 80% to 70% to 60%, the really insidious thing or thing that is not as easy to see is what was the value of that.

So back then, people were lending at 80% of value and value was an inflated appraised value and you could manipulate the underwriting to really push and squeeze the value and get a lot of leverage and now, even without really hammering the LTV, lenders essentially could keep their LTV the same. Let’s say 75% but because of the way they’re underwriting, they are pulling everything back and getting way more conservative in every way and really constraining in how much they’re willing to lend.

So it is amazing to see in this environment that even with some small tweaks without really going out there and saying it explicitly like, “Hey we are not making loans or we are only making loans at 60% you could see everything tighten up even just behind the scenes.”

[0:17:50.9] WS: So how does that change the type of properties you are looking for, the requirements of those properties that you are starting to underwrite? Like you said, even the deals that not only has the deal flow shrunk but just the deals that you are willing to go through the process of underwriting, how has that changed?

[0:18:05.0] RB: So we are definitely moving up in quality.

[0:18:08.2] WS: Why moving up in quality? When you say up in quality, you mean like maybe we’re looking at A class where before we were looking at B minus and C.

[0:18:15.5] RB: Right, exactly. So it is just higher quality assets are typically just more resilient and recessions and uncertain times also not to say that there is going to be pain in any particular asset class or category, A, B or C and everybody is going to see price decline. Everybody is going to see some level of stress, it is just an opportunity to get into some nicer properties that we are previously priced out of. Certainly on the class C side, there will be deals that were over levered.

That were particularly impaired because of a lack of collections and unable to service debt and they will be some distressed opportunities. I don’t think it is going to be widespread but there will be some unique opportunities and they’ll most likely be on the worst assets, which we will not shy away from. We will definitely be looking to actually buy the debt from lenders to then foreclose ourselves on these distressed assets or buy them from the banks and make attempts like that.

Which will definitely be more so occurring on the worst quality assets but in terms of buying something today before the distress is really hit and before material price declines have come, I definitely see that making way more sense to do so in the class A, A-minus, B-plus space then looking for a C asset right now before prices have really adjusted to where it becomes attractive.

[0:19:34.6] WS: Nice, so I love what you are saying but it goes into what do you see over the next few months? Where are you all going to be very serious about buying again or maybe you are serious now, maybe you could elaborate on that or are you going to wait three months?

[0:19:47.9] RB: It is funny because if we look on LinkedIn or Facebook, there’s people out there saying, “Well, there is great opportunities still out there in the market” and things like that and yeah, I really don’t think so. I think it is a very difficult time to be buying right now just because unless you have a seller that’s working with you on like we said, a 10% price adjustment roughly because the change in conditions on the debt side alone demands a 10% reduction in price.

So unless you have a seller that is working with you on that it is a very difficult time to buy and so we are really hoping that we’ll be able to get back in the market in a meaningful way in the next three months and I think that will be impart be determined by the debt markets when are bridge lenders going to be back in business, CNBS and when do the reserve requirements burn off from agency loans. I think the debt markets will lead the way on that.

But yeah, we are definitely looking every day. We want to understand the market but we’re not really expecting to find anything in the near term.

[0:20:45.0] WS: So, tell me a little about how your underwriting three months ago or the types of underwriting you are doing then helped you prepared for what’s happened now?

[0:20:54.1] RB: Yeah, so I think we are definitely all in this together and we are all learning together, which is good and some stuff I wish I would have done more of before and some stuff I am just learning as we go but I think something that is really straight forward is just having ample reserves. Our rule of thumb pre-crisis is it was to have for a permanent loan deals, loans that were typically less leveraged and longer maturity, so overall lower risk.

We would have a reserve account of at least one month of operating expenses and for bridge loans that were generally higher leveraged and shorter term so they were a maturity risk and things like that we would do two months of operating expenses as a reserve and now that we are all in the middle of this, I am thinking, “Well maybe it should be two months and three months” so upping that reserve. I know a lot of people are talking about reserves now and how invaluable they are and it is really true.

So that is something that we’re doing before but I think it can’t hurt to do even more of and it is on my list of things to do and write about this to actually perform an analysis on the return drag of having an extra amount of reserves. What it does on the returns right? Because if I have to hang on to an extra million dollars in my reserve account obviously that is burning on my pref and it is dragging down my returns but is it worth it?

And so it is in analysis that I want to do in the near term to understand that better for myself. So that is number one is reserves and I would say what we were doing before, we were always as you know generally conservative. So not reaching for the stars on our performa rents, being more realistic on our economic vacancy and not forgetting to factor in things like rent concessions and employee discounts and model units and bad debt.

Just making sure that we have enough vacancy cushion there to incorporate all of that because I think right now we are seeing obviously rent growth is stalled and all of that is really what is making a lot of deals three, six months ago look good was big rent growth and big rent increase from renovations and that was something that we always shied away from. We pretty much always underwrite our deals with just two percent rent growth and 2% expense growth. So we are really looking for the deal itself to be able to pencil on its own.

[0:23:11.7] WS: Nice, grateful for you explaining that even going into reserves, how you are calculating reserves too because that is always a question I get as well and I ask operators on the show and you’re one of the few who actually has a way of saying, “Well this is how we calculate it” right or wrong you have a way that you methodically think about it and this is how we have done it and so I feel like that is good because if something happens that teaches you, “Well maybe that wouldn’t as much.”

Or maybe it is too much or whatever that may be, you know how you are calculating it so now you have a point to go from at least to make it improved, you know? We’re about out of time unfortunately but I’d love to hear a little about I know you go into this in your book as well, sensitivity analysis a little bit and maybe you just give us a minute of what that means exactly and then different analysis that you stress more than others that we definitely need to watch.

[0:24:01.3] RB: Definitely a fun topic. So sensitivity analysis are really just different test and tables that you can create and evaluate to synthesize your returns across various outcomes and assumptions. So you could synthesize different vacancy rates and see how that affects your returns and you could really look through the different assumptions and see which one affects your returns the most. So there are some things that just by exploring you can see that they don’t really affect your returns that much.

So if you miss on your cap X budget and this is what I found just through underwriting so many deals, if you are off by a few 100 thousand obviously depending on your deal size but a few hundred thousand dollars on your exterior cap X budget it is not going to kill your deal. So, people say, “Well what if the parking lots are bad and you have to redo them all for 50,000?” and you say well, it is not the end of the world. You know not really going to change your returns that much.

But if you are off by $25 on your rent performa that is a huge deal. So we’ve got $25 or $50,000 right? There is different ways that assumptions affect your underwriting. So my favorite sensitivity analysis is the exit test and this is something that is a must for lenders and I think it is really important for borrowers as well but it is basically your ability to exit the loan that you are planning to put in place. The way you do that is essentially you take your existing loan, your proposed loan and you determine its maturity.

So let’s say you’re going to take a three year load or a ten year loan, you are going to proforma out your PNL out of that maturity date of three years, 10 years, five years and you’re going to see what are my projections at that maturity and with a base case assumption about the capital markets about what our interest rates is going to be then, what is leverage going to be and different requirements like that.

And see what is my new loan going to be and is my new loan going to be greater than my existing loan because if it is not, you are going to be in trouble. The lender might force you to sell so they can get their money back or you might have to come in with fresh equity to a capital call, which nobody likes. So I think we refinance exit tests tell you so much about the risk of a deal especially if you are taking on a bridge loan because a bridge loan has a much greater maturity risk than a 10 year loan.

Because in 10 years almost all deals will be in a better position than where they are now today but in three years especially with a bridge loan which really is lending based on future, you really want to stress and see, “Well if I am off on my rent, if the market isn’t as frothy as it is today and cap rates are up and my valuation is down am I going to be able to refi out of my bridge loan or am I going to get hung and have to come in with fresh equity would be forced to sell it at the worst time?” So that’s my favorite stress test.

[0:26:45.6] WS: Awesome, I appreciate you going into that. Lots of listeners have questions about how we check how sensitive the deal is and then our underwriting. So incredible Rob, one final question, how do you like to give back?

[0:26:55.9] RB: I think right now I am definitely in the stage of my life where I am still trying to learn from mentors and soak up everything I can so I am not always thinking about giving back but what I am always willing to do is jump on a call or answer someone questions and often I get an inquiry that I just can’t see how it could add any value to me and I will still just get on a call and share my knowledge freely and give candid advice and just really try to be helpful because somewhere in me is a teacher and I do enjoy that.

[0:27:26.9] WS: Awesome, Rob I know this will be a popular show everybody is trying to just hone their skill of underwriting and getting better at it and I know your book is going to be very popular amongst the listeners and myself, I can’t wait to get it. I hope you are going to send me a copy and I hope it is autographed as well by the way but anyway, Rob grateful for your time and grateful just for you sharing on the show and giving back in that way. Tell the listeners how they can get in touch with you and let them know how to find your book because by the time they hear this it is going to be out there.

[0:27:55.4] RB: Yep, I am working on it right now, I am really excited for it. So I highly encourage you to head to lonestarcapgroup.com, right there at the top or anywhere else you will find it you’ll see a link to click to get a free copy of my underwriting model sent directly to you and then from there, there will be additional information on getting my book and just getting more involved in what we do. If you want to email me directly with any questions you can reach out at [email protected].

[0:28:22.0] WS: Awesome Rob, great show.

[END OF INTERVIEW]

[0:28:23.9] WS: Don’t go yet, thank you for listening to today’s episode. I would love it if you would go to iTunes right now and leave a rating and written review. I want to hear your feedback. It makes a big difference in getting the podcast out there. You can also go to the Real Estate Syndication Show on Facebook so you can connect with me and we can also receive feedback and your questions there that you want me to answer on the show.

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[OUTRO]

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