The cash flow metrics of multifamily syndications are usually the ones that get the most attention from passive investors. In my first syndication investments, I rarely looked at any of the other numbers as long as I knew, liked, and trusted the sponsor and vetted the location of the asset. In the Left Field Investor’s Deal Analyzer worksheet, which is available to our Infield members, there is a section called Primary Metrics to input the internal rate of return (IRR), average annualized return (AAR), cash-on-cash returns (CoC), and equity multiple. Most real estate investors understand that these terms deal with the financial returns that will hopefully be generated from a given investment. The purpose of the Deal Analyzer’s Secondary Metrics is to help investors assess the riskiness of a multifamily deal.
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1” – Warren Buffett
When reading through the private placement memorandum (PPM) and the executive summary of a syndication, it is easy to stop your evaluation after you have approved of the CoC and equity multiple. I urge you to continue your due diligence of the pro forma numbers to determine the risk of the investment by looking at these secondary metrics. This should be of paramount importance and will give you more peace of mind when you wire that large sum of money to the sponsor.
1) Exit cap rate and its relation to the entry cap rate
The capitalization rate, or cap rate, is the rate of return on an investment property that is based on an all-cash (no mortgage) purchase of that property. It is calculated by taking the net operating income (NOI) and dividing it by the value of the asset.
Entry, or going-in, cap rate is the cap rate at the time of purchase and should be consistent with those of nearby comparable properties. Exit cap rate, also called terminal or reversion cap rate, is used to estimate the property’s value at sale. As you can imagine, predicting cap rates 5, 7, or 10 years into the future may be difficult. Most experienced passive apartment investors will advise you to make sure that the exit cap rate is at least 0.5% higher than the entry cap rate to help ensure that the underwriting is conservative. I personally like to see the difference closer to 1%. Some sponsors will display a range of exit cap rates in a table to show you the differences in the investor returns. If the sponsor can show that the apartment will give you a good total return despite illustrating worse conditions at the time of the sale (i.e. higher exit cap rate), then you should have more confidence in their pro forma numbers.
Here is an example of how changing the exit cap rates can supersize the sale profits.
Purchase price: $12,000,000
NOI: $600,000
Entry Cap Rate: 5.0% ($600,000 / $12,000,000)
Example 1
Exit Cap Rate: 6.0% (1% higher than at purchase)
Year 5 NOI: $900,000
Sale Price: $15,000,000 ($900,000 / 0.06)
Example 2
Exit Cap Rate: 5.0% (no change from time of purchase)
Year 5 NOI: $900,000
Sale Price: $18,000,000 ($900,000 / 0.05)
While it would be great to have the exit cap rate in example 2, a sponsor who shows you example 1 is being more conservative (and probably more realistic) with the underwriting. Comparing the entry and exit cap rates is one of the first things I do when looking at the executive summary.
2) Yield on cost minus the market cap rate (Development Spread)
Yield on cost (YoC), or return on cost, is an often-overlooked metric that is a more complete version of the cap rate since it takes into account the stabilized, pro forma NOI, which may not occur until years 2, 3, or 4, and the total project costs. Therefore, YoC is the stabilized NOI divided by the sum of the purchase price, capital expenditures, and closing costs and fees.
The difference between the YoC and the market cap rate is known as the development spread. If the YoC is 6.5% and the cap rate is 4.5%, then the development spread is 2%. For value-add multifamily assets and development projects, you should be looking for development spreads of at least 1.5% to 2.5%. Since this metric shows how much value can be added to a project, higher spreads are more desirable.
Brian Burke’s excellent book, The Hands-Of Investor, goes into more detail about this concept and a related, but more comprehensive, metric called development lift.
3) Break-even Occupancy
The break-even occupancy is the economic (not physical) occupancy rate at which all operating expenses and debt service is covered. Thus, the resulting cash flow would be zero. Lenders prefer to see a break-even occupancy of 85% or less. For multifamily assets, our LFI Deal Analyzer suggests a break-even occupancy of 80% or less. I have seen multiple deals with a published break-even occupancy of under 70%. Assuming the underwriting is accurate, a low break-even occupancy percentage should give you confidence that the asset could survive a high vacancy rate due to unforeseen circumstances. Remember that all real estate is affected by its location so you will want to make sure that the break-even occupancy of the prospective investment property is also comfortably lower than the average surrounding apartment occupancy rate.
4) Default Ratio
At first glance, the default ratio appears to be similar to break-even occupancy. It is calculated by adding the operating expenses and debt service and dividing that by the effective gross income. Essentially, it gives you the break-even income (not occupancy) needed to cover the expenses. In our Deal Analyzer, we suggest a default ratio of 85% or less.
5) Debt Service Coverage Ratio (DSCR)
DSCR is a measurement of the asset’s cash flow to pay the current debt obligation. Most banks are comfortable if the NOI divided by the total annual debt service is equal to or greater than 1.25. If a syndicator has put out the offering and has secured a loan, obviously the lender is comfortable with the amount they are providing for the deal. In terms of deal analysis “stress tests”, most sponsors and experienced passive investors would agree that break-even occupancy and default ratios are more important than DSCR.
6) IRR Partitioning
IRR is considered by most investors to be the preferred metric to compare the overall returns between deals because it combines the profit with the time value of money. As the saying goes, “A dollar today is worth more than a dollar tomorrow”. In comparison, average annualized return does not take this into account. As an investor, you want to see cash flow as quickly as possible so that you can have access to that money for other investments.
IRR partitioning (IRRP) takes this one step further by separating out the two main components of the returns: cash flow from operations (rental income, pet fees, late fees, laundry income, etc.) and cash flow from the sales proceeds and return of capital.
The cash flow from operations (CFO) is relatively more stable (i.e. less risky) than the income expected from the resale of the property. Rental income comps are easy to determine so the month-to-month cash flows are going to be more predictable. Because the exit cap rate may change by the time the sponsor decides to sell the asset in 3 to 10 years, the cash flow from the sale could be anyone’s guess.
After plugging in the pro forma cash flow data from many multifamily deals into my IRR partitioning spreadsheet, I have come up with some ratios between CFO and sales proceeds. On average, most of the 5-year multifamily deals had an IRR partition of 25/75 (CFO/Sales). In other words, the cash flow from rental income comprised 25% and the sales proceeds and return of capital comprised 75%. Ideally you would want to see the CFO percentage higher because this would mean that the returns will come back earlier – i.e. you have less of your money left in that deal.
For pro formas that are shorter than 5 years, the IRRP ratio will typically be skewed towards the sales side (more like a 20/80 split) because there will be fewer months to collect rent. And the opposite will be true for long holds like 10 years. These deals may approach closer to 50/50 because of the long rent collection time frame. Development deals and heavy, value-add properties will have a greater separation between the two percentages (assuming no refinance), such as 10/90 or 15/85 splits because rent collection will be low in the early years. Stabilized, A-class multifamily apartments that cash flow within the first few months should have percentages that are closer, such as 35/65 or 40/60. So if I see a 35/65 split on a 5-year hold, value-add, multifamily deal where the sponsor does not anticipate a refi, I’m usually interested in that deal and will further analyze the other metrics.
For more information on IRR partitioning, watch this video from one of our Left Field Investors Zoom meetings.
Conclusion
Investing in assets that have less risk will help you grow your money faster. Continually educating yourself and networking with others will also prove to be invaluable. Reading through PPMs and executive summaries can be daunting, but understanding these six metrics, among others, should give you more confidence in whether or not to invest in a given deal. The LFI Deal Analyzer can help guide you to make better decisions about investing in apartment syndications.
Steve Suh is an ophthalmologist and is one of the founders of Left Field Investors. After owning a few small residential rentals and seeing that it was not easily scalable, he transitioned to the world of passive investing in commercial real estate syndications. He enjoys learning and talking about real estate and hopes to educate more people about the merits of passive investing. You can contact him at steve@leftfieldinvestors.com.
Nothing on this website should be considered financial advice. Investing involves risks which you assume. It is your duty to do your own due diligence. Read all documents and agreements before signing or investing in anything. It is your duty to consult with your own legal, financial and tax advisors regarding any investment.
