Deal Analysis: When Is There Too Much Debt?
Below is an analysis recently completed for a client. Some of the transaction details were omitted and some numbers have been modified to maintain the confidentiality of the sponsor. In this scenario, the sponsors are presenting a high quality apartment complex mostly finished with a renovation project (except for refreshing some of the units), yet is no longer an attractive investment due to the amount of debt.
Prepared for <Confidential Client>
Date: Summer 2021
Executive Summary
- This is a solid property and excellent market
- The assumptions in the prospectus around rent growth are reasonable
- The sponsor is paying a premium price to purchase a mostly renovated property in a high growth metro area
- The proposed debt amount relative to the existing cash flow in this project, in my opinion, make this an unacceptable risk
Deal Overview
The sponsors are purchasing a 120 unit apartment building in a Western US City with a population of more than 1,000,000 people. The property is an older garden style design, recently renovated Class B property in an area with Class A multi family properties. The sponsor is offering a 6% preferred return followed by a declining profit split from 70/30 to 50/50 between sponsor and the partners as the property hits specific rate of return hurdles.
The investment thesis is straightforward: The sponsors are paying a premium price for a quality asset, finish the slow renovation, and enjoy market rent increases. The projections include 2% rent increases and the property likely will outperform these projections. Population growth in this market and high construction cost to add new units is leading to a prolonged housing shortage and continued rent growth.
The story on this property is likely that another owner bought it, completed 90% of their improvement plan, then decided to sell it for most of the projected returns without having to wait out the final few years. The slowest part of an apartment improvement / reposition is waiting for tenants to move out so individual units can be refreshed. Owners don’t want to force out long term paying tenants just to renovate, so this process is slower.
The other numbers in this deal make sense. It’s a good property and market and the project will likely turn out in line with the sponsor’s projections.
Critical Issue
The property currently has between $990,000 and $1,100,000 in net operating income (cash flow) depending on which numbers and adjustments are used from the presentation. The proposed purchase price is $24,000,000, or around a 4.5% capitalization rate. My first reaction is “they’re overpaying for the property”, but the market is what it is. This appears to be a good market, good location within the market, and decently renovated property, even if it’s a 1973 original construction date.
The sponsors are proposing almost $19,000,000 of interest only, three year financing on the property, then projecting extending this loan for an additional two years at interest only. Interest only financing is appropriate during construction, but questionable once the majority of renovations have been completed. Financing is loose right now, but nearly $19mil in debt against +/- $1,000,000 in cash flow is very aggressive. (~5.8% Debt Yield) Further in the deck, the sponsor states the financing terms aren’t finalized.
This level of debt exposes the project to a total loss scenario if rates move up more than 0.75% (late 2018 rates) or if financing terms change with the agencies (Fannie Mae and Freddie Mac) requiring principal and interest to be repaid before projected rents grow into the deal. In my opinion, you want to look for syndication deals where the downside risk is mediocre returns, not a complete loss of capital. The proposal they’ve created exposes investors to a total loss scenario while the sponsor has limited their potential losses. The risk / return for this deal no longer is acceptable due to the risk of a total loss.
In my opinion, the structure that would create an acceptable risk / return on this transaction would require more equity, something along the lines of 65% deb and 35% equity. If the renovations/rent increases work out, the sponsor can then come back and do a cash out refinance a couple of years into the deal and secure 25-30 year commercial mortgage debt. This would return part of the equity the investors put in and secure a long term financing structure to pay distributions from for the following 5-10 years. Similar returns could be accomplished without putting the investors at risk of a complete loss.
In summary, the sponsors are buying an asset that only yields 4.5% at purchase, attempting to engineer enhanced returns with an amount of debt, and I believe this exposes an investor to an excessive amount of risk relative to other investment options available.
Deal Review – Key Takeaways
Debt Yield: Divide the Net Operating Income by the Total Debt to get a Debt Yield. In today’s market, this number should be in a range of 7.5%-10%, with the higher yield generally indicating a safer transaction for the investor.
Spread between NOI and Debt Yield: The investor should also look for a good spread (2% or more) between the Capitalization (Cap) Rate and the Debt Yield. This shows the property can eventually make some level of debt repayment through cash flow. This transaction was presented with a 4.5% Cap Rate and a 5.8% Debt Yield.
Financial Engineering: If you are looking at a property that’s generally stabilized, compare the capitalization rate to the presented returns. How big is the difference? The underlying capitalization rate on this asset was 4.5% yet the prospectus presented double digit returns to investors (after management fees!). Immediately this causes me to ask how? The answers are usually aggressive financing, aggressive revenue increases, or lower capitalization rates at exit. In this case, it was financing engineering the projected returns.
Robert Chase is the Principal Consultant at Professional Deal Evaluations and provides risk reviews to investors for private real estate transactions and funds.