How To Vet An Investment Opportunity In Under 10 Minutes

For today’s episode, we will be discussing how investment opportunities.

You know, there are a few key factors to look at, these carry the most weight

We will go over the most important one thing to vet right away.

We will talk about these things…and more in another episode of Multifamily Investing Made Simple in under 10 minutes.

Tweetable Quotes:

"understand your investment goal, your parameters, and understand what the operator is putting together." - Anthony Vicino

"Check out the operator and make sure they are a good fit for you. And they've got a track record and they've done this before." - Dan Kreuger

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Transcript

Anthony Vicino: [00:00:15] Hello and welcome to multifamily investing made simple in under 10 minutes, this is the podcast where we take the complexity out of real estate investing so that you can take action today. And on this day of all days, we are going to take the complexity out of how to vet an opportunity in under 10 minutes. So when a deal comes across your table, how are you going to look at that thing? Because the timer is ticking before you have to get your funds in and make a decision whether or not you want to be in this rodeo or not. And so every minute that ticks by is one moment that you might never get back and somebody else might take your place in the deal. And that would be very sad. So without further ado, let's get into it. Dan, how do we vet an opportunity?

Dan Kreuger: [00:00:56] Let's do it. So if anyone on here listening to this has looked at an opportunity before and they were newer to it, they'll know that it could be a bit intimidating. There's a lot of information they've got to try to absorb and understand before you feel comfortable and confident to invest your hard-earned capital into an opportunity. But when it comes down to it, there are really a few key factors that one should be looking for in an opportunity in order to assess how risky it is and, you know, how much money they're going to make and if it's a good fit for them. So in an effort to make this as simple as possible, we're going to identify just a few key factors that are going to carry the most weight in an IS performance. So starting from the top, I mean, we tried to get this one of the way the operator, obviously we're going to be talking more about financial metrics and things you should be looking at. But before you get to any of that, you've got to make sure you're working with a good group of people that are aligned with your investment goals and parameters. So the most important thing you got to do is look at the operator. What are they done before? How long have they been in business? And does their business plan, their strategy in line with your investment parameters? The big one they've got to check off.

Anthony Vicino: [00:02:13] This is the most easily the most important one. But also, if this is the first deal that you're ever looking at investing in, then you've probably waited too long. If you haven't even vetted the operators at this point in the process, you probably should have done this in the weeks or even months leading up to this deal coming across your plate. Now, if you're a more experienced corporate or investor and you've maybe passively invested in a handful of other people's syndications and you're familiar with how it works, then maybe it's OK to see a deal for the first time from an operator and then go through that vetting process with them. But this is a pretty important one. So don't put this off until the deal is over on your table at that's probably a little bit too late in most cases.

Dan Kreuger: [00:02:55] Yes. So big one. Check out the operator and make sure they are a good fit for you. And they've got a track record and they've done this before. So once you get past that point, then it's time to look at the actual opportunity that this group has presented you with. And like I said, there's a few there's a handful of things. They're going to be the biggest items that move the needle the most with respect to the risk profile of the deal and what you could expect to get out of it. And I've got a few queued up here. What do you think is probably the biggest one? People need to be looking at it from an underwriting perspective, or I guess not even just, you know,

Anthony Vicino: [00:03:33] Even before I get I'll let you handle the underwriting staff. Before we even get to that, I would point out something that you mentioned already, which is to understand your investment goal, your parameters, and understand what the operator is putting together. What's your business plan? You know, we value add multifamily guys and we deliver returns within a certain, you know, range. If when you're looking at our dealership and you see, oh, actually, that's falling below my expectations. Well, that makes it really easy to vet that deal. You're like, nope, that doesn't hit my return threshold. Or if the business model is maybe a little bit riskier than what you're comfortable taking on, then you can just weed through that right away and say this doesn't hit my objectives. And so you can save yourself a lot of heartaches before you even get into the numbers just by understanding the story and the business plan that's going to be executed and then understanding how does that fits with my objectives. And then once you're past that, then you look at the returns and that's the next hurdle to get over, which is, OK, if you want a minimum 10 percent cash on cash return, let's say we're to start out a number and this deals only turning back nine percent. Well, that's a really easy decision. Just doesn't hit the metric. Right. So on or if it's close enough, you just go deeper into understanding what were the underwriting assumptions and is it that it's just very, very conservative and in a more realistic environment that they might actually hit your threshold? So there are some variables there to understand. And so to understand how conservative or aggressive the underwriting is, I think we'll turn it over to you and dive into a couple of those metrics now.

Dan Kreuger: [00:05:08] Absolutely. So one of the big ones that move the needle a lot with respect to the underwriting portion is the cap rate. And it's not the most intuitive thing for people who are new to this industry, because the cap rate is something that you really just hear about in the commercial real estate world. But just know that it is a multiplier that is used in the valuation of a multifamily asset. And it's a move the needle quite a bit because when an operator acquires an asset, they're acquiring it at a certain cap rate and that's going to be somewhere close to the market cap rate for that area, that asset class. And the way this can really move the needle a lot is the operator's assumptions about what that cap rate is going to do over the whole period. Specifically, if there's going to be a refinance at some point, what are their assumptions about what the cap rates are going to be there? And then at the end of the deal, what's the cap rate projected to be on the exit? And it's tough to forecast five, seven, ten years out into the future, but everyone's got to do it to some degree to figure out what their assets are going to sell for at years five, seven, 10, or whatever.

Dan Kreuger: [00:06:20] They're going to sell it. And a little movement in that cap rate can have a big impact on the valuation of the property. So what is common out there in the underwriting world of the multifamily world is for that cap rate to incrementally go up over time, which is actually in. Firstly, correlated to the value of the property, so a cap rate rising actually means that the market's getting softer and that you're not going to get paid as much for the same cash flow in the future. That would be a conservative approach to the cap rate assumptions. But it's very often to see it's very it's not unlikely for you to see operators who have a flat cap rate for the entire whole period, which might very well be in line with reality, or they might actually have their cap rate going down, which is a fairly optimistic view of the next however many years that one moves the needle quite a bit.

Anthony Vicino: [00:07:16] That one's so big that it bears repeating and kind of diving into an unpacking even more. Charles Gibbins, who is the real estate syndication lawyer, says that the cap rate is the most powerful force in the universe, which I don't know about that, but it is pretty darn powerful. And when you mentioned that it's hard to project into the future five to seven years, I would say it's not just hard, it's impossible. Nobody can accurately forecast what the weather is going to be like tomorrow, much less than five years. And so a market that's a very complex environment. Nobody knows what it's going to look like. Everybody's crystal ball is equally murky. And so without having clear precedents and understanding of what the future's going to hold, it behooves us to always er on the side of assuming that the future is going to be worse than the present. And if you do that, then when you get to the future and it is in fact worse than the present, then you won't be disappointed. The people that go astray I think are their underwriting. They tend to assume, oh, it's what's happened. What's happening now is going to keep happening, growth is going to continue happening or it's going to be good. And then they find themselves in a five-year window looking at a disposition in an environment where things got worse. Oh, your numbers no longer work. And not only do they not work, but if your cap rate, as you mentioned, is off by just a little bit, it's going to affect the overall valuation of your building by a whole lot. And so I think the standard that we implement is about five pips per year getting worse or increasing by five bits. So five basis points every year of the hold. And that just says that every year, the longer that we hold, the higher and higher the cap rate gets.

Dan Kreuger: [00:09:00] Mm-hmm. Yeah. And just to kind of illustrate exactly how big of an impact this can have, if we're looking at a property that we bought at a five cap on day one that had an area of two hundred thousand dollars, that cap rate would imply a value of four million dollars. So if we've got something that produces two hundred thousand dollars of cash flow, we buy it at a five cap. We're saying that's worth four million dollars if we just change that to a six cap. So if we went from a five percent cap rate to a six percent cap rate, the value goes from four billion dollars down to three billion, three hundred thirty-three thousand. So just one percentage point change on the cap rate changes into a big change in the value of the property. So.

Anthony Vicino: [00:09:43] All right. So we're coming up towards the top of the episodes. We've got to fly through a couple more things here to look at when getting an opportunity. And that really for me, it comes down to three levers and these are the levers that we're making assumptions about. So whenever there's an assumption about what the future is going to hold, it behooves us to always er on the side of caution. So we already talked about the cap rate. That's the really big one. The next one I want to talk about is rent growth assumptions and expense growth assumptions always assume that rents are going to grow less or slower than you assume it is and that expenses are going to grow more than you think they are. So whenever you can make an assumption that's less in your favor, you should make that assumption in the underwriting. And so these are important things to look at when you're getting a deal.

Dan Kreuger: [00:10:27] Yeah, and on the rent growth piece, you always want to make sure that when you're looking at someone else's deal, that you're thinking about versión. Are there rent growth assumptions? Are they realistic today, are people projecting that they're going to get rents higher than they've ever been in that area? That's something that you want to be on the lookout for. If you're looking at a deal where they are getting their rent growth because the property was under market rent and all the growth is just getting it up to par with the rest of the market, that's great. If you're looking at an opportunity where they're already in line with market rents and the business plan is predicated on those market rents continuing to go up over time, a little bit riskier. So another big one that you should be aware of is a vacancy. What is the operator projecting their economic and physical vacancy going to be in this property? And does that align with the rest of that market? And does it align with the performance of that operator on previous assets in the past? You know, it's should be pretty straightforward. That's one that should be very clearly spelled out in a deal package. And you just want to make sure that it makes sense to you.

Anthony Vicino: [00:11:38] Basically, yeah. For me, at every point in getting a deal, it's not so much about the numbers as it is about the story behind it and hearing articulated from the operators and saying, you know, vacancy isn't necessarily a bad thing. If the reason that we have vacancies is that we're moving out a bad tenant base and we're repositioning it and that we're doing heavy renovations, we have a lot of units down for a period of time. A vacancy is going to be expected. Right. But if you're sitting down with an operator and they're saying, oh, we're going to have zero percent vacancy, but then you also know that they plan on recycling out all the tenants and doing these heavy renovations, then you start to have these red flags go off. We're like, well, this story doesn't make sense. Like, how are you going to be able to do both of those things? Something's got to give. So, you know, vacancy isn't necessarily bad. It depends on what the story is behind it. In the same way that rent growth or expense growth, all these things, it's about the story behind it.

Dan Kreuger: [00:12:34] A hundred percent, one little bonus at the end here that will wrap it up. That's the debtors. You want to make sure that the debt being used on an opportunely you're looking at is appropriate for the business plan and the economic environment.

Anthony Vicino: [00:12:49] And that's everything that you're going to need to deal in under 10 minutes. I actually think we went a little bit over on this episode, but that's OK because this is an important topic. You don't want to rush vetting an opportunity. Don't get that fear of missing out and jump into something just because it's there. And you don't want to be the uncool kid who misses the bus to school on the first day. I don't know about people, but we appreciate you guys joining us. We'll catch you next week.