Evaluating Risk in Multifamily
Through the lense of a Limited Partner
I’m going to attempt to keep this more brief, but this is a topic I could talk about at length and go down several rabbit holes. Feel free to take me up on it.
Investing is risk vs reward; it’s very plain and simple.
Which would you choose?
Choice A: Hypothetical investment that 100% guaranteed a 5% return
Choice B: Promissory Note to your neighbor Bob for 5% a year
If you wouldn’t choose Choice A from a purely investment perspective (no emotions), stop reading and unsubscribe now.
You wouldn’t choose the same return for increased risk, so the same should be true when evaluating real-life opportunities.
The problem with risk is it isn’t easy to quantify, whereas returns are very easy. You flip through an investment deck and you can see a sponsor says I’m going to make a 15% IRR over 5 years.
But there’s no NUMBER to show what your risk is.
Partly, it’s because risk is subjective and different for each person. Have you ever turned down a property because you didn’t like the city it was in? That’s an element of risk evaluation. You don’t place a high enough value on that location for whatever reason and that’s fine.
But I would bet, that for a lot of those properties, you would be interested in it if it was free.
For example, you might not like tertiary cities because they’re too small and to you that presents too much risk. But, hypothetically, I bet if I gave you a new construction multifamily deal in a tertiary city for FREE, you would take it.
Why?
Because its god damn free and now the risk is worth it to you because the reward is crazy high!
You might say that’s obvious, and that’s true because it is, but it helps illustrate how we need to look at opportunities. But now we need to start looking at them with a more realistic lens.
Here’s a much better scenario, you have two identical deals in every single way but one opportunity has rents growing organically at 2% and another at 6%, which would you choose?
Again should be obvious.
But herein lies another problem for most people.
It takes me less than 5 minutes to open an investment opportunity to find out what the expected returns are, but it will take me much longer to find the numbers and do the math for all the different line items to figure out what % increase they’re assuming.
And that’s just one potential risk factor to evaluate! It could take several days to evaluate every single thing to its fullest extent!
So what do you do?
In my opinion, (which is not financial advice in any form) I think investors who are not full-time investors and are just looking for alternative opportunities to put their money in, should come up with several different risks they care about the most and spend time looking at those.
If you can focus your time like that, you won’t look at everything, but at least you’ll hit your personal most important items, and it will at least be better than looking at nothing.
So what are some things to potentially look at?
For below, I’m not including any risks associated with the General Partners or sponsors as I believe that should be evaluated before even looking at any deals they might have. Also, I am just stating possible items that could be used to evaluate and potential ways to look at them. I am not suggesting how you should look at them or how much risk you should associate with them. These are all subjective to the individual and need to be decided on your own, and in no way constitute financial advice.
Here are just a few of the examples I think could work:
Capital Stack
How much debt are they taking out? Is it floating or fixed? How long is the term? What percentage of the purchase price and total cost is it?
After debt is it just common equity or is there preferred equity? Is there any mezzanine debt or 2nd position loans?
What is the use of the capital stack? How much is for purchase, closing costs, fees, renovations, cash reserves, etc.?
How much capital are the General Partners personally investing?
Unlevered Yield on Cost
Divide future NOI by the total capital stack
How does this relate to the exit cap rate? Relate to entry cap rate?
Rent Projections and Comps
How does this current property compare to the others? How do the rents compare to the others? How does the business plan relate to those properties (level of renovation, services offered, etc.)
Do you feel the comps offered are actually comparable? Are there comps being left out that don’t support the projections? Why were they left out?
Expense projections
Where did these numbers come from? How do they compare to the historical operating figures? Why are they different?
Input variables
Income and expense growth projections, what percentage are they and why?
Taxes and insurance
Business Plan
Stabilized versus heavy renovation
Have they done properties like this before? Do they have bids in hand for the costs of projects? Do they do this regularly so they know the price?
Do they have contingencies and fallback plans?
Market Dynamics
Is the area good or bad? Is the population growing? What is the supply and demand like in this area?
Again, the idea is that if you can pick 3, 5, or 7 risk variables, like these, and use those to evaluate some of the risks you can save time and still analyze at least some of the risk. Yes, it’s slightly more work, but now more than ever it’s very important to understand the different risk profiles for each deal before investing your hard-earned money into something.
You’ll very quickly realize that 2 deals projecting a 15% IRR return, are in fact not at all the same.
All the best,
Chris Grenzig
Owner
JAG Capital Partners | JAG Communities
Chris@jag-communities.com