For those of us in finance or investments, it’s easy to forget that people outside of our activity may not always understand the terminology or jargon that we use in our everyday life. In my case, it is real estate, specifically investment terminology in Multifamily housing. The more I talk to people and potential investors, the more I realize that even though they may understand certain terms and concepts, there are others, where they have a vague idea, or frankly do not know at all. Though these concepts may be completely foreign, sometimes it may be hard to admit it — much less ask the questions.
Some of these terms are qualitative, like asset class, property type [a, b & c], stabilized property, core, core plus, value-add, opportunistic, etc. While others are of a quantitative nature such as Cap Rates, Cash on Cash Returns, IRRs and Equity Multiples.
It is for this reason that I wanted to write this and do it, as simple as possible to facilitate the communication and insure that we all understand each other by speaking the same language. I think that the best way to proceed is to ease ourselves into the subject by addressing the basic qualitative terms and concepts before tackling the more complex quantitative ones.
So, Multifamily properties are an asset class within the commercial real estate space, covering that wide spectrum of residential properties that contain at least four housing units. For our purposes, I will focus on apartment rental communities as this type of properties are the most commonly sought assets for investment purposes.
Since apartment rental communities are not created equal (and for analysis and investment purpose), we need to be able to compare apples to apples. The industry created a simple classification scale which is basically a way of placing properties with similar characteristics into specific buckets [ A, B & C]. This classification is done based on several criteria such as property age, quality, amenities, rent, location, etc...
Class A properties are those at the top of the food chain, offering near resort-like features and amenities to its tenants. These properties are best in class assets and command the highest possible rents in their respective markets, while providing the lowest returns in the asset class.
Class B properties are those that are below the Class A properties in terms of age, quality and amenities. The rents are thus lower than in the Class A properties as these type of apartments, are mainly targeted to mid income earners. We, at VTS Capital Partners, focus on this type of properties for a variety of reasons that may warrant a separate blog …
Class C properties, are the lowest tier in the multifamily segment. They are mostly older assets, with outdated buildings systems, infrastructure, design or finishes and for these reasons, these properties are quite cheap to rent as they are in desperate need of renovations. Quite often, they are occupied by lower income renters.
Other terms that one invariably hears mentioned are Core, Core Plus, Value-Add and Opportunistic. These are classifications corresponding to investment strategies commonly used in the industry and are basically defined by the quality of the property and level of risk to be assumed.
Core: This is a low risk, low return profile strategy suitable for the most conservative investors. Core strategies are mostly focused on stabilized properties which are best in class properties that require minimal capital improvements, present minimal tenant turnover and generate strong and steady cash flows. Despite commanding high rents, these are usually fully leased. The focus of these investments is cash flow, as given their profile, they do not normally provide significant upside in terms of appreciation, but do provide predictable cash flows.
In some cases, you will hear about a Core Plus strategy, which is nothing more than a Core approach in properties with a bit of upside due to the opportunity to increase the Net Operating Income [NOI]. It is still a lower risk profile strategy and one could say that this is a step between Core and Value-Add, with more risk than a traditional Core strategy but less risk than Value- Add Strategy.
Value Add: this is a medium to higher risk profile strategy with a corresponding (medium to higher) return profile. This type of strategy is usually employed in properties that exhibit management or operational problems, require moderate physical improvement, and perhaps suffer from capital constraints. The assets are usually acquired with the objective of creating or extracting value through the execution of improvement activities designed to address the previously mentioned issues. These include, but are not limited to upgrading the property’s look and infrastructure, adding amenities, looking for additional sources of income, managing costs, etc. The final objective being, to increase occupancy levels and rental income to eventually impact the value of the property itself. Therefore, this strategy requires a short to medium term hold as a sale is eventually required to monetize and extract the value resulting from the value-add process.
Opportunistic Investments: This is a high risk and high return strategy. It is utilized in properties that require a significant amount of work in terms of renovation needs, severe underperformance characterized by high vacancy rates, etc. Often, this strategy requires a certain amount of new development, for these reasons it implies higher risk but also provides the highest possibility of return. Additionally, the opportunistic approach may be applicable to financially distressed properties that may have been overleveraged during the acquisition process or may have deteriorated themselves to this status, due to gross mismanagement, significant deferred maintenance or a combination of the above. It is not uncommon to hear a conversation along the lines of, “we are buying the property at a 5.0% cap rate, our cash on cash return will be 7.0%, after a 5-year hold, we are projecting an exit cap rate of 5.5%, which will result in a price of $XYZ million and, when it is all said and done, our projected IRR will be in the 18% range with a multiple on equity of 3.0x.” These guys are deep into some of the basic quantitative elements of real estate finance.
Cap Rate, a.k.a. Capitalization Rate: this is the basic measure of a property’s operating performance. The capitalization rate is the unlevered rate of return on a property based on the income that the property is expected to generate. It is used to estimate the investor's potential return on his investment and it is calculated by taking the Net Operating Income
[NOI], which is nothing more than a property’s revenue, minus the operating expenses, and dividing the result by the purchase price of the property (or for a current cap rate, the market value of the property). The cap rate is useful in many ways [a] It allows an investor to compare properties on the same level, [b] by dividing the NOI by the minimum cap rate an investor is willing to accept, it allows them to estimate the maximum price they would be willing to pay for a property. Finally, [c] assuming stable cash flows, it is useful in the calculation of the investment pay-back period by dividing 100 by the cap rate. As with all financial indicators, the cap rate should not be used as the only reference when making investment decisions.
Cash on Cash Return: This is another measure of investment performance. it represents the distributable cash flow before taxes. This is calculated by dividing the annual pre-tax cash flow by the total cash invested in the property. Basically, it tells you what your return on invested cash is on a given year. Though, a helpful indicator to start your analysis, it is not a good indicator on its own, as it does not tell you the whole picture in terms of an investment’s return over time. For this we need to look at the Internal Rate of Return [IRR] — more on IRR below.
As investors, we need to look at this indicator carefully to not be misled by high cash on cash
returns as this value is also highly influenced by the level of leverage on the property. The higher the leverage the higher the cash on cash return would be and that at some point could be dangerous.
IRR a.k.a. Internal Rate of Return: if you were to ask someone with a financial background, what an IRR was? you would probably get back, something like, “It is the discount rate at which the NPV of an investment is equal to zero.” Nice, but what does that mean in plain language? Well, basically, it is a calculation of the value an investment generates over the entire holding period. Simply put, the IRR is the percentage of interest rate you earn annually on each dollar you have invested in a property during the period of time during over which you own it. The calculation takes into consideration the capital invested, all the cash flows received
(including capital return) and the time value of money. This considering that the value of a dollar received in the future will be worth less than that of a dollar that we receive closer to the present.
Equity Multiple – The equity multiple basically tells potential investors what they are expected to get in return for each $1 dollar invested, without any concern for the length of time it takes
to generate the return. It is important to remember that when we talk about return, not only do we consider the gains from the investment, but also the return of the initial $1 dollar invested. So, a 3.0X multiple simply means that for every $1 invested in the project the investor got back or is expected to get back $3.0. It is calculated by taking the total of all profits or distributions received (including the total equity invested) and dividing it by the total equity invested. As with all the other key indicators that we have discussed this is a good indicator, but should not be used as the sole metric to evaluate an investment as its relevance is higher for shorter term projects than for those that take a longer time.
Thank you for taking the time to read this blog, I hope that the content has been helpful to you and if the feed-back is positive, I will be happy write about other real estate or investment topics that may be of interest to the readership.