I am often asked by fellow investors how to sift through the noise and the marketing materials of a deal presentation. I understand that the amount of information shared can be overwhelming. Therefore, in today’s quick snippet I offer three key performance indicators passive investors can focus on to determine if a deal is worth looking into further (you have to appreciate that for a detailed oriented individual, limiting myself to only three was an arduous task 😊).
1. Positive Leverage. Usually that is measured as the cap rate at purchase (unlevered return) is exceeding the all-in interest rate on the loan (cost of capital). I prefer to look at Yield On Cost (YOC) at stabilization instead as the YOC captures not only the purchase price, but also other costs associated with acquiring the property such as closing costs and capex. Thus, if the YOC exceeds the interest rate on the loan, this is usually a good indicator of positive cash flow and returns.
For example, if a property is purchased at $22.75MM and generates actual trailing 12 month NOI of $1.475MM, the purchase price cap rate is 6.5% (=1.475/22.750). If closing costs and capex amount to $2.1MM and stabilized NOI is $1.8MM, then the YOC is 7.2% (=1.8/(2.1+22.75). Thus, a loan interested rate of 6.1% would yield positive leverage in both scenarios.
2. Cash Flow On Day 1. I measure that as rental income generated by the property today (assuming no increases in rent) vs. the sum of operating expenses (adjusted for increase in insurance and taxes) and debt service. If the NOI less debt service is positive, that is a strong position to start with. Bonus points if NOI meets the min 1.25x debt service coverage (which is the typical minimum set by lenders).
3. Low Break Even Occupancy Of 80% Or Less (with a strong preference for 70% or less). The break-even occupancy is the sum of operating expenses and debt service divided by effective gross income. It effectively shows the amount of cushion, or in other words by how much can income reduce before it hits a level sufficient to solely cover opex and debt service. Any income below that level, would result in negative cash flow.
The common denominator across all three KPIs is cash flow, which is what covers the expenses and ultimately (along with the gain on sale) generates investor returns. Cash flow and cash reserves are the cushion that help an investment weather the storm during periods of market volatility. Hence, the importance to meet these KPIs on Day 1.
If a deal does not hit those KPIs but you still want to look into this further, it is worth a discussion with the sponsor to better understand the sources and uses for the transaction, how they are mitigating the thin or negative cash flow risk in the beginning, and why they still think this is a good investment.
Nevertheless, unless one is looking for higher risk, not meeting these hurdles on Day 1 would give one a pause, at least for me, as I like to invest for cash flow.
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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.