MF Case Study Update

[Ashley Wilson]

A little over a year ago, I wrote a post that received over 10k views. Based on the popularity of the post, I thought it might be worth posting an update, especially because the outcome is quite ironic! Before, I get to the update, here is my original post:

Recently I came across a deal that we previously offered on, but was awarded to another buyer. I did a high level comparison where we differed in our underwriting and here are the results:

1) Rents: They projected over $300/unit rental gains, whereas we projected $140. The differential is due to the comp set. If you do not recognize the true comps to your property (ie. what prospective tenants consider when looking for a place to rent), you can put yourself in a precarious position; one in which you can never get ahead. The reason this is very dangerous is because not only does it impact your cash flow, but it also impacts your ability to exit as pricing is typically based off of the NOI approach.

2) Natural Appreciation: Currently there is some healthy appreciation in the market, however, is that going to continue at today's rate for the next three years? This sponsorship believes it will. In comparison, we underwrote appreciation for Y1, and then scaled back for the subsequent years.

3) Inflation: I have seen this on so many offerings and I am not sure why it is not being called out. If inflation impacts your income, it should impact your expenses. Too many times I have seen underwriting accounts for inflation in income but not in expenses. This was the case in this Sponsorship's underwriting too.

4) Economic Occupancy: Economic occupancy almost always is less than physical occupancy. The Sponsorship's model had economic stabilized occupancy greater than today's current, historic and future forecasted physical occupancy. Typically, the only way to achieve such high occupancy is when the rents are below market. I already mentioned how aggressive their rental gains are, so I am not sure how occupancy can keep up when the rents are so high.

So what does this all mean? When you are vetting an investment opportunity, I am a huge proponent for vetting the team first, the market second and the deal third. However, when the fundamentals of the underwriting do not make sense, that is more a reflection of the team than the deal itself. To translate everything above in an offer price, we offered only 83% of what this Sponsorship paid for the property. This is not the only deal that our offer has been off by ~20%. More and more deals are trading for insane prices. Some may argue we should just sit on the sidelines for a bit or change our underwriting, but we are not doing either. We are sticking to our fundamentals. While we may not get a lot of deals, the deals we do get will be worth the wait!

Ok, so now the update!

So the ($22) million dollar question is how is the property doing? Well funny you should ask! A couple of weeks ago I received a call from one of the partners who bought the property. They told me that they have heard of me from multiple people who said that if anyone can get a property performing it is me, and that they desperately needed my help. While I appreciate the compliment, the situation is quite difficult because they paid way too much basing their price (and business plan) on an unobtainable reality. Just as I had noted a year ago, the rental projections were too high. (Side note: there has been tremendous rental growth over the past year, so the fact that they still couldn’t hit the targets is scary!) The other things I pointed out also came to fruition: natural appreciation is not occurring like it was a year ago, inflation DID impact their expenses too (obviously), and the economic occupancy actual and future projections are aligned with the historics, thus not even close to their projections. So what did I do?

As much as I would love to help this group out, as I have done for other owners/operators, I think this investment opportunity is past the point of saving. Personally, I think the partnership should minimize the loss and be transparent with their investors. Specifically, I think they should arrange a discounted sale even if that means they lose money. As that is a tough pill to swallow (especially on the ego side), multiple investors are opting not to do this. Instead they are holding the property until the very last minute when the lender takes the asset. This is, obviously, the worst outcome that could happen for all parties involved.

There is a very famous saying that has become a key guiding principle in real estate fundamentals: Money is made when you buy. Over the past few years this basic concept has been forgotten. Numerous investors (even very famous ones) were quoted as saying real estate values always go up. Today we are witnessing the fallout from investors who relied more on factors they could not control (interest rates, market demand, inflation & appreciation) than the ones they could (basic operations). In fact, I would even argue that it was their lack of operational knowledge that got them in the predicament in the first place.

*** You can follow more of my thoughts here:)