In part one of this two-part series, Paul Kaseburg, head of acquisitions at MG Properties introduced us to how sponsors evaluate real estate deals — the tools they use, the assumptions they make, and the metrics that investors should pay attention to.

Now we go deeper into what Kaseburg considers the real value of the base financial model—to evaluate the “risk-adjusted side of the risk-adjusted return.”  He challenges investors to think like lenders and focus on risk metrics to determine if a deal is worth the investment.

 

Where Do You Stand in the Capital Stack?

 

Contrary to popular belief, the value of the base financial model is not to tell you what the IRR will be of a given investment project, but to determine the likelihood that the deal deviates from the expected returns. Lenders want to know how their loans compare to the property value at the point of sale.

The loan-to-value (LTV) is a simple calculation — divide the loan amount by the property value — and you get a lot of information concerning the risk of a given project. “For a stabilized deal, the LTV is normally below 65%, especially for a multifamily property,” Kaseburg says. “As you start to leverage up toward the 80 percent range, the deal starts to be more aggressive.”

When you layer in preferred equity or mezzanine debt, you get much higher into the capital stack, which could result in high LTV ratios. “That could be a very good thing or a very bad thing depending on how the deal goes,” Kaseburg says.

This is why LTV trumps IRR when evaluating deals. You should know where you stand in the real estate capital stack and avoid obsessing over promoted returns. A low-leverage deal provides more of a cushion between the loan balance and the property value, which is good if a model doesn’t perform as expected, or if there is any kind of market shift.

 

Another Simple Yet Powerful Calculation to Consider

 

Kaseburg highlights another number that lenders care about — the debt service coverage ratio (DSCR) is used to measure the risk of a property being able to pay off the debt service. To calculate it, divide your net operating income (NOI) by the annual loan payment.

For example, if a property has $125,000 in NOI and $100,000 in annual mortgage debt service, the DSCR is 1.25. “Lenders will offer loans to properties with low DSCRs like 1.1 or a 1.0 if they believe there’s a turnaround story but a more conservative coverage would be something like a 1.3 or a 1.4,” Kaseburg explains.

If you don’t find the DCR particularly intuitive to evaluate risk, Kaseburg uses a stress test that takes the distributable cash out of a property divided by your total revenue. “And that’s the distributable cash after you pay your debt service and all of your CapEx,” he points out. “This ratio tells you, on a percentage basis, how much your revenue can go down before you can’t pay the lender and you default,” he says.  

This is an easy number to calculate yourself and something that is not always offered in marketing materials or models. “You can look at that and say, ‘my revenue can go down 25%, and that feels pretty good because, despite the risk of half my upcoming leases rolling over in two years, I can shelter the storm’,” Kaseburg adds.

In that example, you would focus your attention on the risk of that rollover. What would make that particular tenant stay or go? And all of a sudden, you have focus. You can ask follow-up questions that are specific to a unique situation. This the proper way to conduct a thorough due diligence.

 

Adjust Your Analysis For Different Projects

 

Kaseburg reminds us that investment strategies come first — whether you choose a stabilized asset or prefer a project that requires major development to add value — evaluating deals has more to do with assessing risk than comparing projected returns.

“If you start out with lower-risk core and core plus opportunities, you’re buying good real estate already. In this case, stress tests and the DSCR are important because the net operating income will not be moved through property improvements, so the project is sensitive to market downdrafts,” Kaseburg says.

“When you move up to more risky investments like value-add deals and opportunist deals, returns are affected by the operational changes you make to the property, and these changes are expected to generate more revenue as a result. In this case, the DSCR and stress tests are less relevant to determine risk.” Now it becomes about the execution.

Kasebrug wants investors to understand that there are market risks and execution risks, and the latter takes into account the expertise of the sponsor and the platform they have in place to go out and do what they’re planning to do. In this case, investors should ask:

  • Once all the work is done, is someone going to pay more for that space?
  • How is the capital stack different in rehab projects? Is a shorter term floating rate loan being used?
  • Is there debt risk as a result of more aggressive shorter loans? Could the rates go up?

 

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Evaluating real estate deals goes beyond looking at the expected returns, and focusing instead on what can go wrong. Whether it’s capital markets changing or a heavy value-add deal with high marketplace risk and execution risk, Kaseburg says everything flows together, and investors have to list all the risks out and make sure they understand how they interact with each other because they can compound.

This is also what makes real estate investing so exciting. If you know how to measure risk like sponsors do, the likelihood of spotting opportunities in the due diligence phase go way up. Arm yourself with the best knowledge in order to find the best deal possible.

 

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Tyler Stewart is VP of Investor Relations at RealCrowd. All opinions expressed by Tyler and interviewees are solely their own opinions and do not reflect the opinion of RealCrowd. This article is for informational purposes only and should not be relied upon as a basis for investment decisions.