How to Invest in a Volatile Market

[Ellie Perlman]

The goal is to be extremely conservative, analyze all risk factors, and make sure to put emotions to the side when considering a new deal. When looking at a deal, make sure to leave extra slack in your projected operations to account for the potential of short-term instability without neglecting the long-term potential of the investment. Some of the adjustments to projections we are making at Blue Lake to account for our unprecedented time:

- We review returns assuming no rent increases for 12–24 months

- We assume a higher bad debt (delinquencies) up to 4 times as much as current delinquencies

- We assume 2–3x higher vacancies

The bottom line is that investors need to be comfortable with balancing the weight of potential short-term risk with the weight of potential long-term rewards when examining a transaction.

What Factors Should You Look for as a Passive Investor?

Here we’ll outline 7 general factors that each passive investor should consider when looking at a deal.

Factor #1: Deal’s Debt Terms and Structure

The first factor is the debt terms of the deal. Understand whether the deal has a fixed rate or a floating interest rate. A fixed-rate debt is far less variable and thus safer than floating-rate debt. Also, look to confirm whether the loan is conventional or a bridge. A bridge loan is usually short term (1–2 years, though can be longer), which means you’ll need to refinance the deal once the loan matures. Returns might be better in the short term with a bridge loan, but there’s uncertainty with future debt terms in a few years, since nobody knows if you’d be able to refinance with 3% interest rate or 5%, for example, and that can significantly affect your bottom line.

Factor #2: P&L Analysis

Profit & Loss (“P&L”) statements are also important factors in evaluating a real estate deal. Ask your syndicator to see the current P&L and compare it to the projected proforma. Look at current property’s vacancies, bad debt (delinquencies), and rent collections and compare those numbers to the proforma; if there’s a huge increase in income (say, 25%), ask if this is reasonable and why the syndicator thinks they can get there, especially during a pandemic. I’m not saying it’s not possible. All I am saying is that before you invest in a deal, you need to feel comfortable with the syndicator’s plan to grow the income.

Factor #3: Exit Cap

The third factor is the exit cap rate, which is the rate of return investors pay for upon sale. Exit cap is the cap rate that the property’s buyers pay when the syndicator sells the property. Higher exit cap means lower real estate prices, and since we came out of a decade of prosperity, it’s only reasonable to assume that the market will not be as strong when you sell in a few years, and hence cap rates will expand, as real estate prices go down. So exit caps should be higher than in-place cap rates. In other words, the cap rate you bought the property with should be lower than the cap rate you sold it with.

However, if the market your property is located in has a turn for the better, it will be sold at a lower compressed cap rate in the actual future, in which case you reap the reward of extra return without taking any additional risk.

Factor #4: Capital Expenditure (“CapEx”) Reserves

Capital or replacement reserves is the money set aside for one time improvements to the property (such as replacing roofs, fixing HVAC systems, etc). You should pay attention to how much money the Syndicator plans to keep as Capital Expenditure reserves or "CapEx" reserves. A good rule of thumb is 10% of current budgeted capital expenditures to be saved as reserves. These funds protect investors and deal returns because they can be used as an operational fallback to address unexpected expenses. They can also be a source of funding in case vacancies or delinquencies are high due to COVID-19, though not ideal.

Factor #5: COVID-19’s Property-Specific Impact

The fifth factor is COVID-19 and its impact directly on the property. The way the property was already impacted by COVID is a good indication of how sustainable it might be from the next recession. Look for specific information about decrease in rent collections and an increase in delinquencies.

Obviously, if any tenants have been infected, or if inefficient preventative measures haven’t been put into place, this will reflect an additional risk to the buyer and yield a higher property-specific cap rate/lower fair value of the property.

Factor #6: The Business Plan

The sixth factor is analyzing the Syndicator’s business plan for the deal. If the Syndicator intends to spend money currently on renovating and turning over units, this is likely a red flag in a tight environment like today’s where liquidity and occupancy are key. Make sure to ask why this is still a solid business plan. Again, this is a red flag, but it doesn’t mean there’s not solid reasoning behind it. If possible, ask to see the underwriting for a case where there is no renovation plan, at least for the first 12 months, and see how that impacts returns.

Factor #7: Organic Rent Growth

The seventh and final factor is focusing on organic rent growth. Organic rent growth is increases in rents which are not derived from renovating units and pushing rents, but rather are simply derived from increasing demand in the local market or year-over-year inflation factors driving prices up. In other words, it’s growth in rent just by forces of the market, and not because you had to improve the units to “justify” rent increases.

In order to analyze the deal conservatively, best practices would be to analyze the deal with rent growth assumptions set at zero or very minimal for at least 12 months, since we assume it will take time for the market to come back to normal. If the deal still makes sense under these assumptions, then the return assumptions of your project are more aligned with and driven by operations, while simultaneously reducing correlation to market downturns, then you are looking at a solid deal.