As a provider of joint venture and general partner equity, real estate investment firm RanchHarbor has been seeing an influx lately of multifamily investment opportunities presented by sponsors as value-add. However, upon a closer look at the underwriting, these deals do not actually fit the typical value-add investment profile, says Adam Deermount, co-founder and managing director of the company. Instead, these opportunities end up being cap rate compression plays under the guise of value-add and are priced to perfection in today’s market.
“Most of the return on investment is generated by rent inflation buoyed in the early years of the investment by positive debt service arbitrage due to interest only terms,” Deermount tells GlobeSt.com.
Now here’s the rub: If a value-add opportunity requires market annual rent growth of 3% over annual expense growth of 2%-3% over a five-year hold for the returns to work, it is not a really a value-add deal. ”True value-add plays have renovation or management or leasing risks so the increase in value from those activities should be enough to achieve returns in order to justify the risk on a shorter-term hold.”
This is particularly important in this current environment where net operating income growth in major urban markets is likely to see headwinds due to urban flight, a lack of affordability and a recessionary economy, Deermount says.
The bottom line, he says, is that market appreciation plays without rent growth is a rather dangerous way to play the market if cap rates do not contract and rental growth stagnates.
At the same time, debt in the multi-family space is still readily available and fairly aggressive, thanks to the GSE’s willingness to offer both relatively high leverage and extended interest-only terms, Deermount says. ”As a result, a large amount of positive arbitrage may mask other risk factors.” For example, a sponsor can buy at a low in-place yield (high price), yet generate a large cash-on-cash return by levering up with IO debt, eventually showing an exit where it appears as if value has been added to the project, he says. ”However, that value has been added through market-based NOI inflation, rather than execution of a re-positioning business plan.”
Misleading Metrics
Most of the sponsor decks RanchHarbor is seeing of late use leveraged cash-on-cash as a primary return metric. ”While this is valuable, we consider it a secondary metric since it can be easily manipulated higher by leverage and interest-only terms. It says little about the attractiveness in the basis of the underlying real estate.”
RanchHarbor’s favored primary return metric is un-trended yield-on-cost since it cannot be manipulated by aggressive debt or growth assumptions, Deermount says. “Our team has found that the spread between un-trended stabilized yield-on-cost and a market exit cap rate is the best indicator of whether a project will be a successful value-add opportunity. The narrower this spread is, the more likely the opportunity is market-directional. The wider it is, the more likely it is a true value-add investment.”
If a project has a strong un-trended yield on cost, the other metrics (cash-on-cash, internal rate of return (IRR) and multiple) will all fall into place if it is structured correctly, he continues.
“By contrast, a high cash-on-cash yield can be nothing more than an indicator of high leverage with cheap, interest only (IO) debt resulting in a large amount of positive arbitrage despite low unleveraged yields, leaving an investment vulnerable to decreases in revenue or increases in operating expense.”