As a provider of joint venture and general partner capital, real estate investment firm RanchHarbor has recently seen an influx of multi-family investment opportunities offered as value-added by sponsors. However, if you take a closer look at underwriting, these deals don't fit the typical value-added investment profile, he says Adam Deermount, co-founder and CEO of the company. Instead, these options are a compression of the cap rate plays under the guise of value creation and is perfectly valued in today's market.
"Most of the return on investment comes from rental inflation, which was fueled by positive arbitrage of debt servicing due to interest rate conditions in the first few years of the investment," Deermount told GlobeSt.com.
Here's the problem: if a value-adding opportunity requires 3% annual rental growth versus 2% to 3% annual cost growth over a five-year period for return to work, this isn't a real value-added deal. "Real value creation games involve renovation or management or leasing risks, so the appreciation of these activities should be enough to generate returns to justify the risk of a short-term commitment."
This is especially important in this current environment where net operating income growth in major urban markets is likely to face headwinds due to city flights, lack of affordability and a recessionary economy, Deermount says.
The bottom line is that market appreciation without rental growth is a pretty dangerous way to play the market unless cap rates shrink and rental growth stagnates.
At the same time, multi-family debt is still readily available and quite aggressive, thanks to GSE's willingness to offer both relatively high leverage and extended rate terms, Deermount says. "As a result, a large amount of positive arbitrage can mask other risk factors." For example, a sponsor may buy at a low in-place rate of return (high price) and still get a high cash-on-cash return by building the IO debt and eventually showing an exit where it looks like as if the project had added value, he says. "However, this value was increased by market-based NOI inflation, rather than the implementation of a repositioning business plan."
Misleading metrics
Most RanchHarbor sponsor decks see the late use of leveraged cash-on-cash as the primary return metric. “While this is valuable, we consider it a secondary metric as it is easily more highly manipulated by leverage and interest rate conditions. It says little about the attractiveness of the base of the underlying property. "
According to Deermount, RanchHarbor's preferred metric for primary return is a non-trending return on costs as it cannot be manipulated by aggressive debt or growth assumptions. “Our team has determined that the margin between a stable return on costs that has not trended and a market exit cap is the best indicator of whether a project is a successful value creation opportunity. The tighter this spread, the more likely the chance of the market. The wider it is, the more likely it is a real value investment. "
If a project has a strong, non-trendy ROI, the other metrics (cash-on-cash, internal rate of return (IRR), and multiple) will all apply if properly structured, he continues.
“In contrast, a high cash-on-cash return cannot be anything but an indicator of high leverage on cheap interest debt which, despite low non-leveraged returns, creates a large amount of positive arbitrage and makes an investment prone to revenue or decline rising operating costs. "
