Episode 9 of the Fundamentals of Commercial Real Estate Investing is now available on your favorite podcast listening platform. In this episode, RealCrowd Co-Founder & CEO, Adam Hooper, discusses how to evaluate a real estate sponsor’s investment opportunity with Paul Kaseburg, Chief Investment Officer at MG Properties Group.
Paul Kaseburg joined MG Properties Group in 2010 and is responsible for the firm’s acquisition, disposition, and capital markets activities. At MG, he has been involved with the purchase of approximately 12,000 units totaling $1.7 billion in total consideration. Paul has 17 years of experience in real estate private equity investment, capital markets, and corporate M&A. Prior to joining MG, he held various roles in commercial real estate debt and equity acquisitions, development, and financing. He has a background in corporate M&A and venture capital investing at Northrop Grumman (NOC). Paul holds a Bachelor of Science degree in Mechanical Engineering from the University of Notre Dame, and an MBA in Finance and Entrepreneurship from the UCLA Anderson School of Management.
Paul is also the author of the book: Investing in Real Estate Private Equity: An Insiders Guide to Real Estate Partnerships, Funds, Joint Ventures & Crowdfunding (available on Amazon).
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Adam Hooper – Hey Tyler.
Tyler Stewart – Hey Adam, how are you today?
Adam Hooper – I’m great, welcome RealCrowd listeners to the latest episode of the RealCrowd podcast, Tyler who’s on tap?
Tyler Stewart – Adam, we have our first reoccurring guest in Paul Kaseburg, Chief Investment Officer for MG Properties.
Adam Hooper – Yes, we had Paul on a few episodes ago, title of that episode, if you haven’t listened is How to Evaluate Real Estate Sponsored, and highly recommend you go back and listen to that. Paul’s been with MG for about seven years now or so, and he came there about 2010.
Tyler Stewart – That’s right.
Adam Hooper – He’s been involved in purchase of approximate 12,000 units, so he’s got some experience with MG. He came from an interesting background, too, the M&A world, some venture finance world, so he’s definitely seen a lot of things and is a great, a great real estate mind.
Tyler Stewart – Yeah, yeah, it’s great to have him on again. In his first episode with us, he talked about how to evaluate real estate sponsors, and now he’s taken it to that next level of how to evaluate the real estate properties themselves.
Adam Hooper – Yeah, the deal levels. So some of the takeaways today that we talked about, you know, for me obviously, and you know, one thing he stressed very heavily is it’s very basic: read the PPM.
Tyler Stewart – Yeah, no ifs, ands or buts about it, read the PPM. It can be a boring read, but it’s something as an investor you got to do it, you got to do it.
Adam Hooper – So, yeah, also talked about some of the basics that go into financial modeling at the asset level, how some of those assumptions come about. How to look at those assumptions and see, are they in line with market, are they completely wild? ‘Cause again, those are numbers that the sponsor is coming up with that they build their financial projections for the cash flows on the property from, so really kind of looking at how to give a smell test, if you will, to some of those assumptions.
Tyler Stewart – It was a great job by Paul to really point out where the risk comes to play when a real estate company is looking to add value or increase rents, how to identify the numbers they’re using and are they realistic?
Adam Hooper – Yeah, we went in a little bit deeper on some of those other risks too, the financing risk, some of the strategy risk and market risk and some ways to look at those as an investor who might not have the opportunity to go to the property or to some of those tools that you can look at to again, evaluate where those risks fall in line with what may or may not be market.
Tyler Stewart – Yeah, and it goes back to read the PPM. That’s a legal document produced by the real estate sponsor. That’s where they disclose everything, and it might be a boring read, but it’s supposed to be, and as an investor, read it.
Adam Hooper – Yep, pretty good, pretty good advice there. And he also touches again, too, kind of getting back to that first episode recorded with him, it all comes back to the sponsor, right, I mean that’s who you’re partnering with, that’s who’s making these decisions at the real estate level, and that’s who you’re really trusting to be a steward of your capital. So great episode today, lots of good information in there, and with that, let’s get to it.
Tyler Stewart – All right.
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Adam Hooper – Well Paul, thanks for joining us again here today. It’s been a little while since we spoke last time. Had you on a episode prior talking about how to evaluate sponsors, and today we’re excited to dig in a little bit more on looking at the deal metrics and forecasting and as an investor, how you should start looking at some of these offerings. So thanks for coming back and excited to have a good conversation.
Paul Kaseburg – Thanks for having me back, it’s a pleasure, and looking forward to it.
Adam Hooper – Let’s kind of start from the investor perspective. When you’re looking at new deals, whether it’s on RealCrowd or from the country club network, or friend of a friend, what are some of the resources as an investor that you have that you can review to start looking at these projects?
Paul Kaseburg – It’s easy when you’re on the RealCrowd marketplace, obviously, because you have a lot of materials that are right there, but I think the offering materials are probably the first place to start. It’s the easiest, ’cause you can do it from your own desktop. So an offering, the parts on an offering that the investors are going to see right off the bat are usually, there’s a pitch book, which is a slide deck, and it has all the information that you want to see about the property: location and the construction of the property, some information about the sponsor, the game plan for the property, upgrading it.
Adam Hooper – Executive summary of the opportunity essentially.
Paul Kaseburg – Exactly, so you know, that’s kind of the first thing I’d look at is just pull that up, flip through it, and just see if it even fits what you’re looking for in terms of, I’d expect that by the time investors are looking at a particular offering they’ve already figured out how much they want to have in real estate, and then within that, are they looking at, are they looking for an office deal, and are they looking for an equity office deal, and kind of drill down to know whether or not it fits the box generally, and then, and the slide decks the easiest way to do that. And then once you go through the slides, I think that gives you a good sense generally of what the deal is, and then you can really dig into the rest of the offering, which is generally the PPM, the Private Placement Memorandum, and I think, personally I think that if you’re, if you were only going to do one thing, you should read the PPM from cover to cover because it’s just everything you should know about a deal is in there, the PPM’s kind of a unique document because it’s both a little bit of a marketing piece for investors so they understand what the deal is, but from the sponsor side, it’s also something that sponsors use to make sure that they’ve disclosed everything about a deal to investors. And so it’s a legal document that is important for investors to read so that they understand all of, not only just the pretty pictures and the location and the story, but also all the risks involved. So it’s not the most exciting document.
Adam Hooper – You don’t say.
Paul Kaseburg – But it’s really important to read.
Adam Hooper – Yeah, so the PPM, it can be kind of intimidating, right. I mean, sometimes they’re as short as 45, 50 pages, and we’ve seen some 100 plus pages. I mean, that’s a lot of information to try to unpack. Are there certain things as you’re reading through PPM, you know, obviously most have some state required disclosures, disclaimers, a lot of issue, language about the securities and regulatory issues. What are some of the more important sections when you’re looking through a PPM as an investor that you should start looking at, or are you a cover to cover kind of a guy?
Paul Kaseburg – Yeah, well, I would say, I think if you’re making a significant investment, it’s worth just pouring a cup of coffee and going cover to cover, but that being said, it’s worth kind of talking through what’s in there, right, and the important things. So the key parts of a PPM usually are going to be number one property information, and what is the plan with the property, what’s happening in the marketplace, what are kind of the dynamics of that marketplace, jobs, new development, which is obviously an important risk factor, and really kind of understanding the market and the real estate. So that’s one section. And then another section is going to be information on the sponsor. And we talked last time about how important that is. I think if you can only pick one thing, you should really just pick a really good sponsor that you feel good about. So background information on the sponsor, track record, key principles there, the organizational structure, transaction experience, all that is in the PPM which is great to read through. Probably your best resource for it. And then, you know the deal structure in terms of fees, you know we have a very clear fee breakout that explains all of the fees and compensation that goes to the GP from the partnership, and so that’s obviously very important to understand, definitely a section that you want to take a really close look at. You know, there’s going to be typically a section that talks about the legal structure of the transaction, and so what entities are involved is this a tenant in common investment where you’re investing in one tenant in common, are you the only investment in the deal, where’s the money coming from, how’s the deal getting capitalized? So that’s all important to understand. And then of course there’s a big, long section of boilerplate legal risk factors, and that’s pretty daunting and kind of boring to read through, but you definitely should flip through that and make sure, you know, ’cause if there’s an important risk in the deal, it’s going to be identified in that section.
Adam Hooper – Yeah, and so.
Paul Kaseburg – And so.
Adam Hooper – I was going to say, when you’re developing a PPM, how much of those risk factors are kind of stock boilerplates versus property specific risk factors for that individual opportunity usually?
Paul Kaseburg – You know, for us, it is probably 80/20 boilerplate to custom. You know, most of the risks associated with our deals are pretty consistent across deals. So the risk that interest rates could go up is going to be consistent across deals, and sort of the general risks about investing in multifamily are all the same, the risks of leverage all the same. You know, but that will be customized based on the exact loan that we put on the property. So most of it’s boilerplate, but we always sit down and think with every deal, what is unique about this deal? What should investors know about it before they make the decision to invest, and so we always actively have that conversation internally about what do we need to change about our normal risk factors on a deal.
Adam Hooper – Okay, that’s good, and that’s, again, I think the, that is one of the bigger session of the PPM, and the PPM from the sponsor’s standpoint is that opportunity to disclose everything up front and say, “Look, these are all the things we know about this property. These are, again, some of those kind of boilerplate risk issues, and these are some of the risk issues that we see this is specific opportunity.” So there is certainly really good information in there as an investor looking at the deals that I would echo that completely, definitely, look to that section and try to get comfortable with some of those issues that the sponsor’s thinking about that might be some of the challenges or potential risks for those individual properties.
Paul Kaseburg – Definitely, I mean, every deal has risks, right, so it’s just, as an investor, it’s your job to make sure you understand what they are and weigh it off against the upside on the deal and make an active decision that that’s, that’s the investment you want to make. So I think that risk section is key to read through and just see if there’s anything new or unusual that you hadn’t thought about based on your comparison to the pretty marketing materials.
Adam Hooper – Right, and that’s definitely, I think, the Executive Summary and the pitch book is more the, kind of front end marketing, salesy kind of a presentation, where the PPM is more nuts and bolts information, disclosures, and the like, so it can tend to be a little bit more of a dry read I guess but definitely worth it to read through and make sure you’re looking at all those issues for sure.
Paul Kaseburg – Yeah, and once you read a couple of ’em, it starts to go a lot faster ’cause you kind of get the rhythm and the structure and you know where to look and so, yeah, definitely worth the time.
Adam Hooper – And then past the PPM, someone’s taken the time, they like the deal, they like the summary, the sponsor, they get through the PPM, what’s the next step that you would typically look at after you see the PPM and decide you want to take a deeper dive in the deal?
Paul Kaseburg – A lot of groups will put on a webinar where they’ll actually talk about that particular property, answer any questions investors have, and so I think those are great because you can really hear from the horse’s mouth the story about the property. Often they’ll have some operations people on the line, maybe some construction people on the line. And you can also hear some of the questions that other investors bring up, and so I think those are really helpful if a sponsor does that. If they don’t, you can always reach out with direct questions if you have any after reading through it. I mean, definitely don’t be shy, if you have a concern or a question, you want to ask that upfront, because once you make an investment, you’re in it. So better to be careful up front.
Adam Hooper – I was going to say, is a big part of how we’re structured is very much encouraging investors to have that direct communication with the sponsor and asking those questions. And through the webinars the flow that we usually like to see and feedback we’ve been hearing from investors from a sponsor standpoint, what do they like about this deal? What is the strategy for this deal, and ultimately, how are they going to execute against that strategy, and how is it going to make them money, right, that’s the kind of one of the most important things is what are you actually going to do to make what you say happen, happen. And the webinar is definitely a good format for that to come together.
Paul Kaseburg – You can’t beat some personal interaction to get a sense of the people who are actually making the decision.
Adam Hooper – Yeah.
Paul Kaseburg – And then I guess beyond that, those are obviously the sponsor and offering related materials, but you know, if you’re investing, you should definitely be just going online and finding out about it, and a lot of investors will invest sort of disproportionally in their backyard, right, because you know your own city, and you just are more comfortable about the dynamics in your own backyard. And so if it does happen to be a deal that’s near you, I mean, I would, I definitely would go out and drive it and park, walk around, take a look at it, kind of peek in some windows, look at some neighbors. I mean, all of the basic things about evaluating real estate come down to just driving around and making sure you understand whether it’s a good piece of real estate. And if you can’t, I never go out to a property and feel like it wasn’t time well spent. It’s just, it’s always a good thing to do. So if you have time, that’s great, and if you don’t, you know, you can hop on Google Earth, and look at the aerials, look at the uses around there. You can do Google Street View and sort of do a virtual tour around, and that’s kind of the next best thing for you.
Adam Hooper – Yeah, I was going to say, a lot of the investors on RealCrowd don’t necessarily have deals in their backyard, right. We’ve got investors that are all around the country and deals are all around the country. You know, the street view on Google or some other avenues to look at that, what are some other resources as you kind of tour by proxy that you’ve seen helpful out there? Is it conversations with the sponsor, is there another way that you found or you could suggest that might be ways to get some more of that kind of local intelligence?
Paul Kaseburg – Yeah, you know, other than online resources, some of the other actual online resources besides Google are helpful. Things like Yelp, or Google Reviews are actually really useful to understand what’s going on with, they’ll do reviews of an apartment community, right, and you can see what people have to say about where they live. They’ll do reviews of restaurants who might be tenants in a property you’re investing in. And so you can really kind of learn a lot about a property just through online reviews, which is kind of helpful. If you, if you want to kind of reach out to people in the marketplace, really the people who know the most about those deals are brokers in that market, and so if you have the time, you can always just pick up the phone and call one of the local brokers who’s in that space and ask their opinion about a deal, and brokers know just about every property that’s in their market like the back of their hand, and so we reach out to brokers all the time on deals that they aren’t even offering because they’ll know the history and they’ll have opinions about it, and they always have something interesting to add to it. So they’re a great resource.
Adam Hooper – Good, yeah, that’s, I think again, so much of that process of getting comfortable with a deal is really trying to get into the mind of what you guys, as a sponsor, are seeing about it, right. And again, some of these avenues, webinars, direct questions, are really a way for the investors to establish some kind of a connection with that opportunity. Kind of in that line, switching the role to that of the sponsor now, when you’re out there trying to find deals, you know as MG Properties or other sponsors out there, how are you coming up with these opportunities, how are you coming up with some of the property values? Can you kind of walk us through, as you’re looking for deals in new markets or existing markets, kind of what does that process look like from the sponsorship side of the equation?
Paul Kaseburg – We look at a lot of deals. We, last year we closed on a dozen deals, but we looked at hundreds of them. And so, you know, it’s a multi-staged process for us, and really, the goal is to be efficient about where we spend our resources to really understand deals and real estate. And so we kind of go through a stage processes. So we try to kill deals early if they’re not going to be a fit. So we have a real clear understanding of what’s in our box and what isn’t, and if it’s not in our box, then we kill it and move on to the next deal. If it is, then we’ll sit down. We have a weekly meeting internally where we’ll look at all the deals that are on the market or that we have some intel on, and we’ll talk about them, we’ll sort of evaluate the vintage, the size, the location, decide what equity source would be right for it, and just kind of get a basic understanding of it. And if it seems like it’s an interesting opportunity, then usually the next step is we’ll underwrite it. And that involves a full, you know, pro forma financial model, which for us is in Excel, and that’s about a half day to a full day project depending on how unusual and complicated a deal is. And so that’s our first step in really identifying what’s the value of the property and then what are the moving parts.
Adam Hooper – I’m going to pause right there. So for listeners out there that are maybe new to real estate evaluations or underwriting, can you walk us through some of those components that go into that, base, the model as you call it, that would be a kind of a basic financial model where you’re going to project rents, you’re going to project expenses with a certain set of assumptions. Can you kind of walk us through a little bit more detail of what an investor would see in a model that’s typically developed by a sponsor?
Paul Kaseburg – Sure, so the financial model for an acquisitions person is the most basic tool that we have to understand real estate, and the most important one. So it’s like the artist’s paintbrush for us. It’s just the most important thing you have, and it’s, for us, we use Excel. For some other types of investors, they’ll use tools like ARGUS, but essentially the actual math of the model is the same, it’s just how you manipulate the numbers. So it’s a multi-tab Excel model. But really what that model does is it takes all of the cash flows in the deal, so your investment into it, what you do with that cash, and all of the cash that’s coming out of the deal from operations, from the sale of the deal ultimately, and you make assumptions about all of it, and that includes just a myriad of marketplace assumptions, rent growth assumptions, a lot of operating assumptions, and those are built up from all of our, for us, all of our portfolio properties. So we’ll build up from the ground up, what do we think payroll will cost, what do we think we can collect in other income? What are we going to spend in marketing? What are our similar properties running at? How is this one different? And so all of that, really.
Adam Hooper – You’re pulling from your kind of historical experience and what you’ve seen over the life of MG Properties and operating these assets, you’re pulling from that hands-on operational expertise and then using that to build into these models, so you’re not just kind of picking numbers out of thin air, you’ve got your methodology and historical numbers that you can look back on for some of those components, too.
Paul Kaseburg – Yeah, absolutely, I mean for every, for every model that we’re working on, we actually have built into our model all of the, our portfolio comps, so we can pull up a couple of different comps and just look at comparisons for landscaping costs, what are we spending for other properties that are in the neighborhood, and just kind of build those up from the ground up because the way we run it is going to be different than the way the seller runs it, and so it’s, the historicals are a helpful place to start if you’re looking at cap rates and financial history and trends. But really, what matters is the way we’re going to run it once we take over. And so there’s no way around just building that up from scratch. Which is why, minimum, it takes a couple hours just to even load one of these models and kind of put in the basic assumptions. ‘Cause you just have to think through all that, there’s no real shortcut to it.
Adam Hooper – And then with the results of that model, you basically come up with what you feel is a justifiable price for the asset, right?
Paul Kaseburg – Right, so, you know the way in practice what happens is you have this cash flow model, and for investors, really the end number that we’re using to evaluate is going to be the internal rate of return, and so that is telling you what kind of a return you’re getting on your cash investment, end of the deal, over the life of that investment while correcting for the time-value money, so you get an IRR, and you can take that IRR, and the beauty of it is you can compare that to all of the other deals that we’re underwriting, and make some decisions, and kind of correct for risk, correct for the nuances of a particular deal, and then back into a price that you think is appropriate, that will give you a return that you feel like justifies you for the nuances of that particular deal. So for instance, we happen to be looking at a deal right now that’s in a marketplace we know, it’s a very new deal, so it’s lower risk. We plan to use less debt on it, so it’s a little bit lower risk. But it has multiple regulatory agreements on it which makes it more complicated and limits the number of buyers there could be someday. So we kind of look at the other returns for similar deals and just back in to, well, what price makes sense for this, and what return do we need to get to make up for the unique risks of this particular deal.
Adam Hooper – And so now, when you’re, not everybody underwrites properties the same, right, there’s this, some people will get more aggressive in those assumptions and some will be more conservative in those assumptions. What are some ways that investors might be able to look at, you know, at a high level obviously, we’re not expecting everybody to build their own financial model of these assets. If you have those skills, great. But as an investor, what are some of things that you can look at to kind of get a gut check, is this sponsor, are they really pushing on some of these assumptions, is this super aggressive, or is this more of a conservative underwriting? What are some of those different levers in the models that investors can look for?
Paul Kaseburg – I think it’s worth talking about what is the point of modeling, right, and so part of modeling, there are two real reasons to model, ideal. One is to understand what the appropriate price is and to make some decisions about the assumptions that are going into it, and the other is for a sponsor to, it’s almost like a marketing piece for a sponsor to tell investors about the returns that are possible from the the deal. And so there’s a marketing aspect to it, and then there’s an evaluation aspect to it. And so what’s tricky is that for an investor, it’s really hard to evaluate someone else’s model, because these models are just so complicated, and some little nuanced changes to them can make a really big different in the outcome. And so it’s hard to objectively and easily evaluate other people’s modeling. Which kind of goes back to our other conversation about picking a sponsor. At the end of the day, you need to have a sponsor that you really feel comfortable in, because you know that they’re going to be appropriately modeling deals, and that they have, you know, they’re making good, longterm decisions for their investors. So, that being said, there are definitely some things you can look for in models that are key drivers of returns, and they kind of indicate the aggressiveness of a sponsor and of the model. Definitely on the assumption side, the most important assumptions are going to be your rent growth assumption and your exit cap assumption. Your rent growth really is going to define how much revenue you have over time, and if you’re looking at a longterm hold, that will make a bit, you know, small changes in rent rough can make a big different in valuation and return. And so that’s an important assumption. And by default, rent growth, rent growth is a little bit of a weird thing in the marketplace in that rent growth assumptions tend to over a couple years be somewhere in between 2.5% and 4%.
Adam Hooper – I was going to say, And that’s. the straight line 3% growth is kind of the go to rate.
Paul Kaseburg – Right, that’s what it is, yeah. Which is kind of funny because, and I think the reason for that is if you underwrite less than 2.5%, which is sort of like 2.5% is kind of what most people underwrite as inflation, and if you’re underwriting less than that, you’re basically saying I think the world is getting worse, and on a real basis, right. And few people are investing in real estate if they’re opinion is the world’s getting worse. So you don’t see that a lot. And then, above about 4% over a couple years, that tends to be just hard to justify with market reports, and it’s just tough to take that to investment committee, right. So it’s kind of falls in that band all the time. At one point a couple years ago, I was just curious about this, and so I went to one of our market research sources and I had about 30 years of data, and I looked at these different sub-markets, and I looked at the proportion of time that a five year rent growth on average would fall between 2.5 and 4%, because that was kind of the band that we were using a lot of the time, and it was less than 15% of the time did you actually have a five year period that had rent growth in that range.
Adam Hooper – Interesting.
Paul Kaseburg – So the reality is, the market, rent growth is much more volatile than I think any of us like to admit, and we systematically kind of underestimate that volatility, and that’s probably your most important assumption going into a model. So I think it’s important, you know, when you look at that assumption to think about, really, what happens if that’s wrong, and what’s going to happen to this deal. Is it going to have the wherewithal to make it through if it doesn’t go as planned, and what’s my upside here if things kind of exceed what we’ve underwritten? So rent growth is probably the most important factor to look at but it’s also a really tough one to actually accurately forecast.
Adam Hooper – Yeah, it’s interesting that you said 15% of time was it within that band, yet, again, in the years that we’ve been in the real estate industry, I mean, that is just the standard kind of, you plug it in and see where you’re at with that, again, straight line 3% growth. Obviously, very, very market specific, right. The Bay area, you know, last few years, you had tremendous, tremendous rent growth, and now in the some of the more kind of tighter markets in San Francisco, you’re seeing pull back in the rent growth. So I think that just underscores the, I guess the knowledge that you need of those local markets so you can really be a little bit more specific with that and have that history to pull from in those markets versus just that kind of straight line assumption on those rent growths that we see a lot of.
Paul Kaseburg – Yeah, absolutely, and I think that sort of points out the value of modeling, right. The value of modeling and these complicated financial models is not, sort of, the quote unquote, the IRR that you’re getting out of it, because whatever you forecast will be wrong for one reason or another, and so, you know that in advance, and so the real value that we place on modeling is just understanding where are my risks? If something doesn’t go as planned, what does that mean to the deal? What’s my upside, what’s my downside? And so the model is really less about a forecast, a specific forecast as much as it is an opportunity to understand the texture of a deal, and the risk profile of a deal. And that’s, and then compare that to the other deals that you look at, in a long series of deals to decide what’s a good investment and what’s not.
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Adam Hooper – Yeah, and you mentioned the different kind of risk components you look at, too. Obviously a model give you something to be able to stress test against different scenarios, both good and bad.
Paul Kaseburg – Right.
Adam Hooper – You know, some of the risks obviously that you talked about, and that we’ve talked about before in the podcast, financing risk, how levered is the property? You’ve got market risk, you’ve got strategy risk. Let’s maybe take a minute to dig in on some of those. When you’re looking at, let’s start with the capital stack risk, right financing risk, and how you’re actually sourcing the capital. What are some of the components that go into that side of the risk spectrum?
Paul Kaseburg – I guess what we’re really talking about is how do you evaluate the risk adjusted side of risk adjusted return, and what things do you look at that could deviate the investment from the baseline pro forma returns that you see in the marketing materials? And so I think risk, one of the best ways to evaluate risk is to use the metrics that lenders use, because lenders tend to be very risk focused, right, because they’re not participating in the upside, they just want to get their money back and a coupon on it, right, so they use a lot of metrics to evaluate deals, and those are actually pretty helpful metrics for equity investors to look at when they’re looking at it, because if a lender, if a lender flags something as scary, then the equity investor should be really, really scared about it. So they’re helpful metrics, right. So the key metrics that we look at for risk are number one is loan-to-value, and loan-to-value is really simple. It’s just the loan amount divided by the property value, and in practice, that’s actually a really complicated thing because the loan amount could be a number of different things. You know, sometimes you fund a loan and then you take down draws over time, or maybe it’s a construction loan. And so what the actual loan is could change over time. And the property value, you know, is that your purchase price, is that your purchase price plus the capital that you’re investing in the deal, all of the fees that are going into that transaction, is it the value of the property once you do all of the work? And so they’re kind of, you know, loan-to-value, while it sounds simple is surprisingly
Adam Hooper – Some nuances to it, right.
Paul Kaseburg – complex. Yeah, exactly, but from a basic perspective, loan-to-value is a good metric to look at. For a stabilized deal, usually loan-to-value’s below about 65% are on the more comfortable, safer side, especially for a multifamily property. You know, sometimes if you’re looking at an office property or a retail property with some tenant rollover risks, that may not be as safe as it seems, but just in general, kind of below 65% is usually moderately appropriate leverage, safer leverage. As you start to lever up toward kind of end of the 80s, that starts to be a little bit more aggressive, and then of course if you layer on preferred equity or mezzanine debt, you can get much higher into the capital stack, and if you combine that with your equity investment, you could have a very high loan-to-value and so that obviously could be a very good thing or it could be a very bad thing depending on how the deal goes.
Adam Hooper – Well, and as you said, risk adjusted, right, lower leverage, you’re not going to have as much of that return attributed to that leverage so it’s going to be a little bit lower return, but you’re also, you know, more of a cushion between where that loan balance is and what the property value is, which is good if you’re model doesn’t perform as expected, or if there is any kind of a market shift, you’ve got more of a cushion there versus those higher leverage deals where you’re seeing either really aggressive senior loans, or layering in some of that mezzanine preferred equity, you’re going to have a higher return, less equity in the deal, so that gets amplified, but you’re taking on that additional risk so there’s not as much of a cushion between what your, your last dollar in the deal as versus where that loan balance is. So that’s again, I think, a very important part of that risk adjusted equation is where you end up on that loan-to-value ratio.
Paul Kaseburg – There are kind of two aspects of risks that lenders are going to look at. You know, one is, do I have risk at the end of this loan? And that’s where loan-to-value is helpful because it tells you when you sell this, how does your loan compare to the value of the property, at least in today’s dollars or various metrics, and then they also look at what’s the risk that the property will be unable to pay the debt service? And so there are a couple metrics associated with that. So there’s the DCR, or DSCR, which is the debt service coverage ratio, and that’s one of the most common tools used to size that. So that’s the NOI, or the net operating income, the cash flow generated by the property before you spend on usual things like CapEX divided by the loan payment. So how much more cash does the property generate than it has to pay out in the loan payment? And usually a very low debt average coverage ratio would be somewhere like a 1.1 or a 1.0, and sometimes lenders will make those loans if they really believe there’s a turnaround story or something happening at the property, they’ll make it better. And a more conservative coverage would be something like a 1.3 or a 1.4, where it’s a little bit higher. Personally, I don’t find the DCR to be particularly intuitive in term of evaluating risk. We run a little different metric internally which we call the stress test. And the stress test is the distributable cash out of a property divided by your total revenue. And that’s that distributable cash after you pay your debt service and all of your CapEx. And what that basically tells you is on a percentage basis, how much can your revenue go down before you can’t pay the lender and you default, and you have give it back?
Adam Hooper – That’s a pretty important number.
Paul Kaseburg – That’s an important number, right. So, and that’s, that’s not always something that’s in offering materials or models, and so, but it’s a really easy thing to run yourself. And so you can look at that and you can see, oh, you know, my revenue can go down 25%, and that feels pretty good, and then you look through the upcoming leases and you see that you have maybe half of the property is rolling in two years, and you have the potential for revenue to go down even more. And so that really focuses you on what are the key risks here. Well, a key risk here is I have a tenant who’s going to be rolling, and I need to understand what the chances of them staying are versus going. So that stress test for us something that we really focus on to make sure that we understand the risks in deals.
Adam Hooper – Yeah, I mean, to say that depending on the strategy, whether it’s more of a stabilized asset or it’s going to be high value add, or development opportunistic, obviously that’s going to come into play whether you’re looking at the debt coverage ratio or the stress test. Can you kind of spend you a few seconds on how does that change based on the strategy of the asset and what are the risks associated with those different strategies, too?
Paul Kaseburg – The different strategies really, it can kind of bridge the spectrum from you start out on the lower risk side of the spectrum with core and core plus opportunities where you’re buying good real estate already, and you’re just continuing to operate it, right? In that case, things like stress tests and DCR are particularly important because you’re not planning to move the net operating income, you’re not planning to increase operations and improve the property significantly from where you are, so you need to know what kind of risk you have just from a market downdraft. If you’re strategy is you start to kind of move up the spectrum to more risky, you have value add deals and opportunist deals, and those deals, you’re planning to go in and really make changes to the property where you’re making operational changes, you’re making physical changes, and the expectation is you’re going to generate more revenue as a result of that. And so those metrics tend to be less relevant in terms of your risk. Because it’s not really just about your market risk, it’s about your execution risk, and does this sponsor have the expertise and the platform in place to be able to go out and do what they’re planning to do, and is that opportunity actually there in the market? Once you do all that work, is someone going to pay more for that space once you’re done with it? And so there are kind of different risks associated with that. And typically, you have different capital stacks for those two. So you use a different, perhaps a shorter term floating rate loan on a deal where you’re planning to go in and really rehab it and make some big changes because you don’t want to lock yourself in with longterm fixed rate debt, because you won’t be able to resize that debt efficiently, or you won’t be able to sell the property once you’re, you’ve executed your plan. So these risks kind of layer together, and you’ll get, you tend to get perhaps debt risk, where you have a short term floater, that the transaction could be at risk if rates go up or that capital markets change combined with a heavy value add deal where you have high marketplace risk and execution risk. So these things kind of all flow together, and you have to kind of list ’em out and make suer you understand how they work with each other, ’cause they can compound.
Adam Hooper – And that short term floater for listeners out there, not necessarily as into the real estate world, short term floater is basically bridge debt where you’ve got a floating rate, so it’s not a fixed rate. Usually, again, on kind of turnaround properties where there’s a value add component. Anything beyond that, again, some of these terms are probably new for some of the listeners out there. Always good to give a little bit of background there.
Paul Kaseburg – Definitely, and you know, there are just such a variety of debt options out there. It’s just, I don’t think there’s a right or a wrong about what debt is used on deals, but it’s just important to make sure that the debt matches up with whatever the business plan is for the deal.
Adam Hooper – So those are some of the metrics that you said, obviously the bank is looking at. Which are good as an equity investor, as well, to be aware of, and look at some of those as well. When you’re looking, echoing these deals with a financial model, we touched on IRR, what are some of those other investment returns as a sponsor, and then we can kind of unpack what those mean for the investor as well. What are some of those other returns that you guys are looking at, those metrics when evaluating deals? On the investment return side, we have, probably the biggest metrics that we look at are number one IRR, and we’ve talked about that a little. And some of the benefits and drawbacks of that. Obviously it’s very easy to calculate an IRR, but it’s hard to calculate the risk that’s associated with that particular IRR. And also very easy to dramatically change the IRR with very small adjustments, right?
Paul Kaseburg – Right, exactly, so the IRR is very useful, but I think it’s important to kind of keep that in the context of the rest of the investment, right. It’s one metric of many, and not focus too much on that. The IRR is definitely something we look at a lot, because internally, we model things the same deal after deal, and we are aware of the different risks between ’em, so for us internally, IRR’s just a very useful metric. So IRR is definitely you look at. Cash-on-cash is really important. And cash-on-cash is the, it’s the amount of distributable cash you get out of an investment divided by the total cash investment you put into a deal. So it’s really simple. How much do I get out of this deal every year on a percentage basis compared to my investment? That’s one of the most important metrics for many private investors. That’s what we hear from our investors a lot. Cash-on-cash is definitely important. I think it is possible to overstate its importance because it can, you can miss some important attributes of deals with cash-on-cash. Number one, cash-on-cash can be really impacted by the debt that you use, and so if you have interest only debt where you’re not paying down any principle, you’re going to have much higher cash-on-cash as opposed to amortizing debt, where you are paying down principle. Debt also changes the risk profile of the deal because obviously you have to pay down principle as well otherwise you’re going to default. So cash-on-cash can, is an important metric, but it can be impacted by other factors in the deal, and so again, you don’t want to really overstate the importance of cash-on-cash, and like IRR, it’s important to take into account kind of the risk of that cash-on-cash, and you know, risk adjust that. Would a change in the marketplace impact that cash flow, how much of a change is going to impact it, and how much wiggle room do I have before I have trouble paying back the lender? So cash-on-cash, definitely an important factor that we look at. And then we also look at current return, which is what we call the cash-on-cash, but we take into account the amortization on the debt as well. And so that’s not cash that you get in your pocket every year, but that payment down on the debt, you ultimately benefit from that, right, and so that isn’t, that’s just a helpful metric to tell you what kind of return you’re getting on a deal once you take into account your cost of debt and your debt structure.
Adam Hooper – So that’s including whatever principle pay down is in that debt side of the capital stack.
Paul Kaseburg – Exactly.
Adam Hooper – Right.
Paul Kaseburg – So that’s because we’re, we’re just trying to
Adam Hooper – distribute a return necessarily get to correct. but that still needs to be accounted for in those returns.
Paul Kaseburg – Exactly, yeah, we just want to correct for any distortions caused by interest only debt versus amortizing debt. So those are definitely factors for us. And then equity multiple is really important because that’s, so equity multiple is the cash that you get out of a deal divided by the cash that you invested in the deal. So again, really simple metric, that’s over the life of a deal, and so if you, that’s important because if you have a short term deal where you go in and you buy a property, you make some improvements, you sell it six months later, you could have a great IRR because your hold period is so short, but you don’t actually get that much more out of that deal than you put into it because you haven’t held it for that long. And so the multiple takes into account how long you hold a deal as well as the internal rate of return on that deal. And you know, as you’ve heard on this podcast before, you can’t eat IRR, right, so multiple is something we definitely focus on for our investors, and we tend to be longer term investors, so it’s just an important metric to take a look at. So those are kind of, I’d say the four big investment metrics that we look at, and then we layer those in with the risk metrics that we look at, like the stress test and the loan-to-value and some of those other operating metrics.
Adam Hooper – And so now those are metrics at the sponsorship level that you guys look at, but those are also metrics that our investors are looking at when they come into these deals and they look at these different, IRR, cash-on-cash, equity multiple. Current return isn’t necessarily always displayed, but how does an investor’s view of those metrics differ, or should it differ from the sponsor’s view of those metrics? Paul? Hmm, think I might have lost him.
Paul Kaseburg – Sorry, my phone cut out there for a minute. So you know I think for an investor, the way that you look at those metrics is the same as we look at those from the GP side, because we’re all trying to do the same thing, which is to pick the best deals out there in the marketplace. I think the difference is from the GP side, we know, because we’re looking at deal after deal with the same underwriting, we can really compare those on an apples to apples basis, but if you’re an investor, and you’re looking at deals that are being offered by a variety of different sponsors, you’re not seeing the differences in underwriting that flows through those returns, so I think it’s important to look at those metrics, and use them to evaluate deals, but at the same time, you can’t ignore the quality of the sponsor which we talked about last time, is really what kind of drives the deliverability of those returns, and just the overall risk profile of the deal. For instance, the capital stack, it could be great sponsor, but if it has too much debt, there could be risk there that is driving those returns up, but you’re not seeing the risk adjusted side of that equation.
Adam Hooper – Yeah, and so those are mostly what I would consider kind of internal metrics, based on the financial model and projections that you’re looking at. Are there any kind of outside influences that investors should be aware of or check into that can impact those metrics, or any other things, kind of external to the opportunity itself that investors should be researching or asking questions about?
Paul Kaseburg – In terms of looking at the value of a property, looking at the cash flow model is one of three ways that you value a property, right. So there are some other things that are moderately easy for investors to do. Number one is you can look at comps, and you can see what are other similar properties selling for, and kind of think about, how do you adjust for the location of those properties. Just make sure that the property is trading appropriately in comparison to the other comparable properties, and that’s important from a sale perspective as well as just a rental perspective. For apartments, it’s as easy as pulling up the website and seeing what the properties in the area are charging for rents to see if that business plan that’s being proposed makes sense. So comps are important, and from a sales perspective, comps are helpful, because they tell you what other people are paying for things. That’s good because it helps you from being dumber than other buyers, but that’s not necessarily your goal. You want to kind of, you want to decide what a property is worth, not just in comparison to everyone else, right. So there’s, comps is a part of it. Obviously cash flow’s a part of it, and then being, looking at the replacement cost is an important factor. So I think, replacement cost is a really squishy concept. Replacement cost technically means you take all of the pieces that go into a property and you figure out how much it would cost to replace that property, and you decide whether that’s more or less than what you’re paying for it. And so that’s land value which you come up with based on comparable sales of land, the soft costs that you need to spend to actually get the project entitled and approved, the hard costs, the sticks and bricks, and the costs of debt and financing associated with it, and then of course factor in profit that someone, a developer would want to go out and build a property. And so you take all that into account, and see if a property is above or below that that you’re buying. But that can be a little bit misleading in that if you’re buying an older property, it may, it’s not going to be apples to apples to a brand new property. You may not build an apartment property today that is to an ’80s spec with eight foot ceilings and no washer dryers. And so you have to kind of correct for the design and the quality of a property, and so what I would probably focus on a little more than necessarily replacement costs, although it’s a useful thing to look at, is more just how much development is happening in a market, and if there’s a lot of development happening, then you know that it makes economic sense to be building properties. And if it makes sense to build properties, then you know that there’s going to be longterm pressure on your rents. And if there is no development happening, it probably doesn’t make economic sense to build, in which case you know that there’s some upside in your rents before you’re going to face that competitive pressure, and so that’s kind of an easy metric to know whether you’re, the sub-market that you’re looking at is going to face some longterm cap on rent growth, or if you still have a ways to go. So that’s a good metric to look at.
Adam Hooper – Okay, you know you mentioned earlier in the conversation how you were looking into those forecasts when we were talking about projecting rent growth. We had a podcast just recently with Michael Madsen of Real Source basically on economic analysis, some of those tools that they use to forecast these things. What are some of the services out there that provide these market forecasts? How do you get that information? Is it internal, are there external sources, does that vary from sponsor to sponsor? Right, I mean, if you’re all using the same data, why can two sponsor have completely different prices that they’ll pay for a project?
Paul Kaseburg – Right, so for market forecasts in particular, it is a business that has a number of different sources that you could use. So there are third party market forecast services that you can subscribe to. Things like CoStar, who, that also provides of course much more market information beyond market forecasts like comps and property information. Reese, Axiometrics in our space, as well as most the brokerage shops have economic forecasters who forecast rent growth in different markets. And so there are always different groups that forecast rent growth. Sometimes you can get those forecasts through an offering memo. A lot of brokers can provide those forecasts. Sometimes you can go online and just Google that information, or go on some of the brokerage websites to download presentations they’ve given and they’ll have market forecasts in them. So some web research can provide some market forecasts. It’s, personally I think that the value of market forecasts is more about the background information that they provide about the economic situation, the development pipeline, employer gains and losses in the area. All of that is as important as the actual forecast that they make. And like we talked about, those forecasts tend to sort of between two and a half and 4% anyway. And so they all look fairly similar. Most market forecasts, just by their nature kind of miss downturns, because downturns are often caused by things that no one sees coming. And so I think having those forecasts is useful, but it’s important to take them with a grain of salt and really think about what happens if this forecast is wrong. And that’s really the important thing about forecasting is, it’s important to know the background and why that forecast is what it is, but don’t take it too seriously, because like we said, no one really likes to admit the extent of our uncertainty about that.
Adam Hooper – And now to the second part of that question, I’m not going to let you off of here without answering that. How can two sponsors have just wildly different valuations for properties, right? Is that a function of those assumptions going into it, is it the, again, kind of back to the financing, how is that, how is that possible?
Paul Kaseburg – It’s interesting. So there are a number of different things that could drive a difference in valuation between different sponsors. So number one is simply cost of capital. Some groups have a track record, an investor base that allows them to forecast returns that are higher or lower than other groups. And so if you’re a new sponsor, you may need to forecast higher returns to do a deal, and that changes the way you model the deal. So that’s kind of one factor.
Adam Hooper – And so that’s based on what the acceptable return is for those investors, right. If you’re dealing with a bigger institution where they’ve got LPs and managers, they need to have probably a higher return to be able to provide enough meat for all those different layers, versus if you’re syndicating to individuals or private networks, going more direct. And I think that’s one of the things we’ve seen on RealCrowd is there is less kind of middleman in the equation that might allow for a little better return to the investors, that can drive some of those pricing expectations.
Paul Kaseburg – Yeah, it’s just supply and demand and the ability to raise money based on an offering. So all those are definitely factors. And then you know I think the debt assumptions and structures is really a factor that’s different between sponsors and you’ll see lenders provide really different debt quotes to different sponsors based on their track record and history, the volume of business they’ll do with that lender, and the sponsor’s decision about how much leverage to use on the property can really impact the value of a property in that, one way to make those IRR’s go up is often just to use more debt. And so that is, has obviously risks associated with it, but that different strategy between higher and lower amounts of debt can really change your underwritten returns. So that’s a factor for sure. And then some sponsors are going to have different operating plans for properties. Maybe one group has a belief that they can go in and renovate a property to a higher level than another group who perhaps is more conservative about the way the market looks for that property. So that’s a big difference in the way properties are valued and as well as just operating differences. So you know, maybe one group has a really efficient operating platform. We own a number of deals that are across the street from other deals that we own because once you own one deal, once you can share staff betweeb ’em, of course you become more efficient. So there kind of, there are a lot of factors that go into that. But that being said, I’m often really surprised at how close our valuations come out in comparison to other owners, ’cause we’ll compare notes afterward once a deal trades about how we value deals. And we often end up pretty close to each other. On the one hand, we can look at the world very differently, but on the other, sometimes it’s kind of surprisingly similar.
Adam Hooper – And I think, you know we touched on our last podcast together, when picking a sponsor that has that deep market knowledge. That’s one of those areas that you might be able to see it, if a sponsor’s coming into a new market and they win a deal, maybe there’s something they missed that the locals in that market might have caught. And so that’s, certainly some caution around missing some of those nuances of the local market with that knowledge I think again, it kind of gets back to the importance of picking that sponsor.
Paul Kaseburg – Yeah, that track record’s so important, and that’s one of the reasons why it’s helpful to have an existing portfolio that you can use to underwrite new deals.
Adam Hooper – Good, well, Paul, I think that’s a lot of what we wanted to cover today. I mean, I think, if you could kind of wrap up from the investor standpoint again, if you’ve got, hopefully you’re going to spend more than five or 10 minutes looking at these deals, but if you’re looking at your kind of first high level, high level items to look at when you’re evaluating these. I think you mentioned obviously read the PPM, look at some of these assumptions. What would you kind of put those top three or four things to really key in on as an investor?
Paul Kaseburg – Yeah, I think number one like we talked about is the sponsor and feeling comfortable about sponsor quality and their track record and their ability to execute on the game plan. So sponsor definitely I would put at the top of the list. After that, just a property quality and location, and the long term prospects of that quality. I think, of that property is key. And that’s something you can evaluate either by walking around in person or by the online resources we talked about. Just making sure that you’re buying good real estate is, fundamentally, that’s what we’re in the business to do. And then looking at, in that offering, taking a look at some of those metrics we talked about and just deciding if they seem reasonable. Do those growth assumptions seem reasonable? Does the deal fit into all the other comps that are trading in the marketplace? Does that investment plan seem like it makes sense? That’s all key. And then of course, you want to take a look at the fee structure and the GP compensation terms as well. So I think those are kind of the list of things that you want to go through. But of course you will have the time to read through the whole PPM, because that’s very worthwhile.
Adam Hooper – So my takeaway from that is invest in good deals with good sponsors.
Paul Kaseburg – Can’t go wrong.
Adam Hooper – Perfect, well Paul, really appreciate your time again today. We’ll have you back on again soon to start talking about how to look at portfolio construction. I think that’s a very exciting topic for our listeners out there, so we’ll get that going soon as well. And thank you again for your time today.
Paul Kaseburg – Well, thank you for having me, looking forward to it.
Adam Hooper – Perfect, well listeners, that wraps up our episode. If you have any comments or questions, as always, please send us an email to firstname.lastname@example.org, and thanks for listening.
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