Facts vs. Opinions: Let’s Talk About Following the Numbers in an Investment…

**“Do what you can, with what you have, where you are.” - Theodore Roosevelt**

Day after day we come across other investment firms, real estate or not, providing the public and potential investors with information that seems a bit off.

What do we mean when we say it “seems a bit off?”

For starters, I was inspired today to write this post because I felt I had seen enough of the stretched numbers, empty opinions, and sometimes misleading information related to investment offerings. I was scrolling through instagram for a few minutes, and came across a public advertisement by a multifamily real estate firm with a value-add 506C offering to accredited investors. The advertisement stated a return expectation that initially felt “too good to be true.”

After clicking on the link, I was presented with additional deal information, disclosing the following:

an entry and exit cap rate of 3.2% over a period of 5 years;
a current vacancy rate of 0.5%;
a rent growth projection of 6%;
deal financing was from a permanent fixed loan with a 65% loan-to-value (“LTV”);
and had an expected net IRR of 21% of a Class B property based in California.

With that information alone and with my experience in real estate, it made me wonder how does that even make sense?

Our discussion today will review this investment and its metrics, using facts and reasoning. Let us offer you some guidance and break it down:

Cap Rate

The 3.2% cap rate at entry and exit is below average for this type of investment, and it indicates that there is no projected change in the market from the beginning of the investment to the end. (See our post on cap rates)

THE FACTS:

→ One of most recent National Multifamily Cap Rate reports* revealed a national average cap rate of 5.04% for multifamily across all types of investments (core, value-add, and opportunistic). The report also revealed that the Pacific West region (where the property is located) has the lowest cap rates in the country (4.29%) with a downward trend lasting over two years. In other words, evidence is showing us that the investment conviction is more than likely not coming from the cap rate.

→ The formula for cap rate is Net Operating Income (“NOI”) divided by the property value. If the cap rate does not change it means that, based on the formula alone, your:

1) NOI (i.e. cash flow) and property will not change; or

2) the NOI and property value increase or decrease just enough to offset each other; or

3) the property value will decrease enough so that any increase in NOI is offset; or

4) the NOI will decrease enough so that any increase in property value is offset.

All of these scenarios are entirely possible, and does not necessarily need to be a cause for concern; it could even just reflect conservative underwriting. However, when you take into account the other factors and the stated expected return, it might be something you need to look deeper into.

Vacancy Rate

A current vacancy rate of 0.5% is lower than average. So that’s good right? It could be, especially for projected cash flow stability. But when you are looking for factors to justify a higher-than-average expected return for a value-add property, you might want to see that some “value” is going to be added by improving key investment drivers, like vacancy. (see our post on vacancy underwriting)

THE FACTS:

→ One of the most recent reports on US Multifamily Figures** and statistics showed the national average for vacancy rates was 4.0% across all multifamily property types. Class B properties had a vacancy rate of 3.5% and the relevant submarket in California had a vacancy rate of 2.3%. There was a very large drop in vacancy last quarter for the first time, which could indicate the beginning of a trending improvement, but with fluctuating rates and no real evidence of a continued trend, we will not assume that this is a return driver. Besides, a path from 0.5% vacancy to an absolute best-case scenario of 0.0% would probably not be enough to drive the projected investment returns.

We could continue to talk about rent growth, financing and LTV, as well as the IRR number, but I think you get where we are going with this.

CF Capital Philosophy & Closing Thoughts

As investors, we do not speculate. While there are always elements of the unknown in any investment, we focus on what we know, and what facts we can gather to build (or not build) a case.

We would also like to think that we know ourselves. We are a firm driven by integrity, purpose, excellence, and leadership. We know that we wouldn’t have started CF Capital with four core values if we knew we couldn’t look people in the eye everyday and tell them we are sticking to those values through thick and thin. We burn the midnight oil regularly and even lose sleep at night because we want to make sure we do our absolute best to serve our current (and future) partners.

The CF Capital team will always aim to provide you with solid reasoning, backed by as many facts as possible, and will do everything in our power to make sure you are as fully informed as possible. Among other reasons, that is why we write blog posts like this one - it feeds our purpose.

It might seem odd, but we would be quite happy (and feed our purpose) if just one of our readers approached us and started to interrogate us on our past and future deals, using discussion points reviewed in today’s post.

Before we bring the discussion to a close, we would like to reiterate that we are always here for you.

We want to be your resource, even if you want to talk about an investment opportunity that is not offered by us. We would gladly help you find clarity through the facts and the evidence out there in this world. Let’s elevate communities together!

As always, feel free to reach out to us anytime.

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