2 Things To Look For On Your Next Investment!

[Justin Goodin]

Exit Cap Rate – Most people are already familiar with this but it is super important. The sponsor derives their sale price with an exit cap rate (NOI / Exit Cap Rate = Sale Price). Many deals can look very appealing, but with an ‘aggressive' cap rate, there are many aspects of the deal RELYING on that huge sale price.

Example: If the property has an NOI of $1MM in Year 5 and the sponsor is projecting to sell the asset at a 5% cap rate (sale price of $20MM) but instead sells the property at a 5.5% cap rate (sale price of $18.1MM), this can have a huge impact on your returns. Again, keep in mind the exit cap rate is a projection of what the asset expects to sell in 5 years (or whatever the hold period is) and nobody can predict the future.

Solution: Ask the sponsor how they concluded their exit cap rate and where they are getting their data from. Ask if it is realistic for an asset of that size, vintage, and age to sell at that cap rate in 5 years. Ask the sponsor for sensitivity analyses to see how the returns look selling at a higher (or lower) cap rate than they are projecting. - -

Operating Expenses: This can easily be overlooked. Operating expenses can make or break a deal and they should be verified by the sponsor’s property management company (or multiple PMs).

Example: We are currently underwriting to higher payroll costs. There are many companies struggling to find/hire employees. To find (and keep) great employees, we are underwriting to higher salaries because of the increased demand to find workers. Same with insurance and real estate taxes. These NEED to be verified by third party sources to have accurate projections.

Solution: Ask the sponsor if a professional property management company has verified their operating expenses and agrees with their pro forma numbers. Ask how the sponsor concluded their insurance and real estate tax numbers. Look for discrepancies between the trailing 12-month financial statement (T12) and their year 1 pro forma. Everything may be correct but do not hesitate to ask questions.

- - - What are your thoughts? What else should investors verify in the sponsor's underwriting?