Syndication Changes During COVID

[Duke Giordano]

Hello All,

I am curious for some perspective from both the GP side (How you are looking at future deals) as well as, the LP side in what you are also looking for from a criteria standpoint in a future upcoming deal both the short and Mid-term over the next 3-6 months range in relations to specific underwriting criteria, and return criteria and how it has changed post COVID.

For example some deal criteria that may be different for me due to COVID from an underwriting and return standpoint:

Property Class: Looking more at class B now vs Class A or C

Property Expense Ratio: Probably looking more in the 40-45% as opposed to 50-55%.

Cash Flow: Want to see underwriting that is cash flow focused as opposed to more upside.  Not sure how this would be able to be evaluated except the section of a PPM that looks at hypothetical investment.

Rent Increase Assumption: this will be effected when putting off value add plays, maybe look at 0-1% now as opposed to 2-3%.

Renovation per unit: was looking at 3-8 K per unit, maybe now looking at more like 3-5K per unit.

Break Even Occupancy: was looking at 65-70%, now prefer to see closer to 50-60%

Reversion Cap Rate: Previous was looking at 0.5-1.0 over initial, now looking more at 1.0-1.5x

Loan to Value: Prior Criteria was <65-75%; now lloking more for 60-65%.  Also would be much more hesitant with Bridge debt at the moment.

Reserves for GP: was looking for 3-6 months of Debt+Expenses, now probably looking 6-9 months or 6-12 months (Debt+Expenses) as reserves.

Return criteria (Pref, IRR, Eq Multiple): not sure how this will be effected but still looking for similar number 7-8 Pref, 14-16 IRR, 1.9-2.1 Eq Multiple. Numbers need to make sense with meeting above criteria (more conservative underwriting).

GP Fees: Not sure if this situation will change GP Fee structure or how I look at alignment of interest.  Such as acquisition fee, Asset Mgmt fee etc.?

GP Skin in the game: I know this has been debated quite a bit.  Not sure if people (LP's) are looking at different criteria now then in the past?

Thanks in advance for your time and discussion.

[Brian Burke]

Great questions, @Duke Giordano.  

Agreed, I think B will be the strongest.  In 6 months to a year we might see some good deals in C due to foreclosures.  Those will only be good deals if bought at a steep discount.  I think B is going to be the star performer, followed by A.

I don't factor too much weight to this measurement.  Your mileage may vary.

Agreed. Look for the composition of the IRR. Some sponsors can show you how much of the IRR is attributable to cash flow and how much is attributed to the sale. The higher the cash flow portion, the "safer" the investment (given the proper assumptions are used to begin with).

We are underwriting to 0% rent growth for the next two years.  And low to no immediate increase--in other words, perhaps we underwrite to newest leases, but not to comps in the area that are higher.  Just assume that current operations are about as good as it gets for a while.  No rent bumps.

Renovations cost what they cost, some properties only need $3K to $5K, some need $5K to $8K.  I'm underwriting to doing NO renovations now.  We'll do the renovation at year 2 or 3, using the returned lender debt service reserve and/or refinance proceeds to implement the value add when the time is right.  No sense in trying to renovate & push rents now.  Buy and operate everything for in-place cash flow, see if you can push the upside later.

I doubt we'll see any property in the 50% to 60% range, I didn't see that at the depth of the last recession either.  I'd rather stack up on reserves and have the extra cash available if needed than try to find the impossible.

I believe the reverse is true.  Three months ago, I'd be looking at a healthy jump in reversion cap rate for a five to ten year hold.  Now, I might underwrite to almost zero reversion cap rate expansion.  Here's why.  When real estate is the most desirable, cap rates are low.  When real estate becomes less desirable, cap rates go up.  Well, real estate isn't all that desirable now (there are so many unknowns, buyers are being careful), so cap rates should be higher right now.  In five years when we go to sell, real estate should be more desirable (we sell in an "up" market, right?).  Thus, the cap rate should be lower when we go to sell than it is now.  Cap rates have already made (or will soon make, because it's a lagging indicator) an upward move.  I saw this same phenomenon in the last recession.  I was buying at 7% cap rates, and underwriting to 7% reversion caps.  But, I was selling at 6% cap rates when the market improved, and 5% cap rates as the cycle matured.  I suspect we'll see the same thing happen again here.  This is where grand slams are hit.

Indeed. I wouldn't want anything higher than 75% and would really prefer 65%. No bridge loans, unless the property didn't qualify for agency (meaning, hasn't been 90% occupied for 90 days), but if I did do bridge, I'd structure it like agency--take a lower LTV and no renovation reserve.

Agency lenders are requiring 12 months principal and interest reserve (Freddie) or debt service reserve (Fannie).  This money must be put into a lender-controlled account.  So, you probably won't see any deals done without healthy reserves.  Sponsors should go beyond that, however, and raise a significant amount of cash for extra reserves--you can bet that the lender won't allow the property to tap the debt service reserve until there are no other options.  Now more than ever it is critical to not invest with undercapitalized sponsors nor in undercapitalized deals.

Performance metrics are likely to be pretty much the same today as they were previously, the difference is that the assumptions used to arrive at that performance is night and day different.  If you see higher performance, the likely reason is the sponsor is underwriting to last year's reality.

Not likely to see much change here, I wouldn't expect. What is most important is that all of the fees are factored into the capital raise and cash flow projections when the sponsor is forecasting performance.  All too often, they are left out. 

This is the time to invest with the best.  Stick with sponsors that have extensive track records and have been doing this a long time, even through previous cycles.  There's no stronger "skin in the game" than that.