I am sometimes asked – “I have this deal on the table. How do I know if it is a good deal?” Well, it ultimately depends on your own investment criteria and target returns as well as your comfort level with the operator. However, as you dive into the deal itself, in order to assess viability of the projections and expected returns, it is important to understand what key assumptions the operator is making when creating such projections and the business plan. In today’s quick snippet article, we offer just that.
1. What is the projected rent growth rate? Is it supported by rent comps and recent and future market trends?
In the past two-three years, many markets experienced strong year over year rent growth (and in certain markets like Tampa or Orlando double digit growth). This is not sustainable in the long run and the pace of growth will likely adjust to normal soon. Thus, assuming these strong rent growth rates will sustain in the future is not realistic (though it can sure make the numbers look juicy).
2. What are the expenses? Are they in line with market ($/door, % of effective gross income), the appraisal, or other public data (e.g. Costar)? Have they been adjusted for expected taxes and insurance increases? Is the expense growth rate in line with inflation.
3. What are the planned operating reserves? Are they adequate? It is not uncommon to account for at least four months of operating expenses. If one is to be more conservative, reserving for six months or adding debt service to the reserve will create additional cushion and higher comfort level and reduce the risk of capital calls. Are replacement reserves in place and in line with the lender’s requirements?
4. What is the purchase price cap rate? How does it compare to market? And what is the reversion cap rate?
Ideally the analysis will apply the market (vs. purchase price) cap rate as the beginning point and increase that by at least 10 bps/yr until the point of sale. While cap rates may or may not increase by the time one sells the asset, you want to account upfront for potential adverse fluctuations in the market. If cap rates do not increase, then you have adequate cushion.
5. What are the finance terms (LTV, rate, tenor, interest only period, fixed or floating debt, closing costs, etc.) and are they locked in? The lender is the largest partner in a deal. Especially in the current environment where lending terms are being tightened, you want to ensure the underwrite reflects that and builds in adequate cushion.
6. What is the capex budget? Is it based on contractor bids or past experience? Is there a contingency built in? Especially in the current inflationary environment, it is prudent to build in some cushion.
7. How are the waterfalls structured (do the operating agreement, private placement memorandum, and marketing presentation match)? Are dividends used as return on capital or return of capital? Are the preferred return and dividends cumulative (unpaid returns accumulate over time) or compounded (unpaid return is not only cumulative and therefore added to next year’s balance but is also added to the original investment and as such, earns a preferred return on the new higher base vs. the original investment base)?
That is certainly a lot to consider. Nevertheless, these are important questions to ask so you can develop a good understanding of the underlying investment and enter into it with full awareness of the risks, cushion, and mitigating factors. We hope you found today’s article helpful and feel better equipped to dive into this next deal and evaluate the underlying assumptions behind these great returns you see on the offering memo.
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Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.