In this episode, Theo goes over a recent blog post written by Evan an Investor Relations Consultant at Ashcroft Capital called “Coronavirus and Commonly Asked Passively Investor Questions”. Theo goes over the entire blog post and adds additional value by adding additional commentary from his point of view.
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Theo Hicks: Hi, Best Ever listeners, welcome to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I’m your host, Theo Hicks. Each week, we air two podcast episodes that focus on a specific aspect of the apartment syndication investment strategy, and for the majority of these episodes, we offer a free resource or document. These are PowerPoint presentation templates, Excel template calculators, PDF how-to guides, things that will help you along your apartment syndication journey. All of those free documents for past Syndications School episodes as well as the past Syndication School episodes can be found at syndicationschool.com.
In this episode, we are going to be talking about some of the common questions that passive investors are either proactively asking or most likely thinking about as it relates to their apartment syndication investment and the coronavirus. So the investor relations person at Ashcroft Capital, Evan, wrote a nice blog post about some of the questions he’s been receiving from investors, and this link was included in the Ashcroft investor email updates this month. I wanted to go over the blog post on Syndication School today and add my thoughts to the post and go into a bit more detail on some of these questions… Because most likely, your investors are thinking about these questions, and if you are sending out monthly emails, then it might make sense to include some FAQ documents, or in the body of the email address, some of these questions that your investors asking, so that you’re not feeling a lot of one-off questions to save both you and your investors some time. So if you want to follow along, you can.
The blog post’s entitled “Coronavirus and the Commonly Asked Passive Apartment Investor Questions”. So I’m just going to read the blog post and then stop whenever I want to add in my own thoughts. As everyone knows, the world has changed dramatically in a very short amount of time. It started with some warnings about a respiratory disease spreading across the Pacific Ocean, but quickly jumped coasts and ground our economy and country to a halt. When I am speaking to our investors – again, this is Evan, not me saying this – my goal has always been to understand their goals and problems first, and then offer solutions for those goals and problems.
So as I mentioned, you’re gonna want to proactively address these things to your investors, as opposed to waiting for them to come to you and asking you questions. It’s your job to think ahead, understand their goals, what they want, and have the questions that they’re going to want to answered; not things that you want to have answered, but what they want to have answered. Back to the blog post.
However, as Coronavirus and the economic fallout has become the only news reported, those goals and problems have shifted from optimistic (retire early, passive income, doubling money) to conservative (how are you protecting my money?). So as I mentioned in the previous Syndication School episode to this one about communicating with investors, sure, your investors care about making money, but in reality, when push comes to shove, they’re more focused on you not losing their money. So I talked about this all the time, about the principle of loss aversion – people are more affected by losing money than by making that same amount of money. So I have a stronger reaction to losing $5 than I do to making $5. Obviously, their reaction’s even more strong if it’s $100,000 or a million dollars. So based off of the Coronavirus and knowing that your investors are focused on you not losing their money, what types of questions do you think that they’re thinking about? So back to the blog post.
So what questions are investors asking: “How has your business model changed?” First and foremost, Ashcroft and our property management partners are abiding by all CDC, WHO, and local jurisdiction guidelines. We are cleaning common areas and model units more frequently, maintaining more distance during showings, and allowing for work-at-home for our employees when feasible. Additionally, on the asset level, we are doing far more virtual showings through tools like Zoom, Skype and FaceTime.
As I mentioned, I’m gonna reference the communicating with investors Syndication School episode a lot. So if you haven’t listened to that one, make sure you listen to it. It’s the one just before this one. So I’m going to call it the communicating with investors Syndication School episode, without having to say “the one before this one” every single time. But in that episode, I mentioned that for these virtual tours, these YouTube tours, Ashcroft included the links to those in their email updates. So anything special that you’re doing, make sure you’re including the links, so your investors feel as involved as possible. And then obviously, I think it’s pretty obvious that people are following CDC and WHO guidelines, but you can mention that too if you want to. So back to the blog post.
On the investment front, we have always maintained an extremely conservative underwriting standard. Typically, our exit cap rates assume a 10-bps increase in rate per year over our initial cap rate. For example, if we assume that we hold a property for 5 years, the exit cap rate is generally 0.50% higher than our initial cap rate. This makes the conservative assumption that the markets will be worse when we sell than when we purchased the property. So that’s one very important point to make.
So if you did not conservatively underwrite your deals, then those people are having a lot more difficulty right now that people who did conservatively underwrite deals. So a lot of the guys that I’ve talked to in the Best Real Estate Investing Advice Ever show, the regular show, a lot of the people that I talked to about the coronavirus that were obviously facing issues, but were confident that they’d be able to weather the storm was because of their conservative underwriting.
So one example of that would be to not assume that the market is going to be better or the same at sale. Assume it’s going to be worse, which is a higher cap rate, so that’s worth a bet. So even if the in-place cap rate is 5% and then when you sell, it’s an 8%. so it’s 3% higher, if you assumed that 5.5% or 6%, sure, your projections aren’t gonna be accurate, but they’re going to be a lot more accurate than the person who assumed that it’d go from a 5% cap to a 4% cap, or a 5% cap to a 5% cap. Now, the people who conservatively underwrite their deals are looking like geniuses right now. So that is one example, is the cap rate. Evan’s got a few other examples in here, so back to the blog post…
When researching market rents for our renovated units, we historically underwrite rents that are below competitive properties, in order to create projections that we are very comfortable that we can obtain. So what he’s saying here is that when you’re doing a market rent comparable analysis — well, let’s take a step back really quick. So if you have not been conservatively underwriting deals, then this is going to be a great lesson to make sure you’re conservatively underwriting deals in the future. So rather than– if you are facing difficulties right now because of the underwriting, rather than giving up, just take this as a learning experience. Get through it and come out of the other side literally stronger, because now you understand exactly what mistakes were made, underwriting or something else, and just make sure you use all that in the future.
So back to the blog post and talking about the renovated rents. So when you are doing rent comp analysis, the best practice is to determine what the average rent per square foot is for the competitive properties that are obviously close to the subject property, assuming you’re in a major metro area. So let’s say that you look at ten properties that are all fully updated to the same degree that you plan on upgrading your property, and you’ve determined that the dollar per square foot is $2. So rather than assuming that you’re going to get $2 per square foot at your property, you can assume something that’s slightly less than $2 per square foot. That way, not only are you trailing the market leader, but you’re also trailing the average. So if you do that and the projections still net whatever return your investors want, if you buy the deal, then if it is below average compared to the market, then you’re still hitting your projections. If it’s average, you’re exceeding your projections, and if you are one of the market leaders, you’re far exceeding your projections. So that’s huge.
So if something like this happens and rents go down, then you already underwrote lower rent in the first place. So, sure, the rents might go below your projections, but you’re gonna be in a lot better spot if you assumed a below-average rent than if you assumed an average or above-average rent. Back to the blog post.
Additionally, the loans that we place on our properties are generally very flexible and help get us through slower periods. This is why we always stress in the Three Immutable Laws of Real Estate Investing to get a loan that is equal to or greater than the hold period. So if you plan on holding on their property for five years, the loan should be five years or greater. So if you’re doing bridge loans, that’s okay, as long as you have the ability to extend the bridge loan once the three-year period is over. So back to the blog post…
As the markets adapt to a post-COVID-19 world, we will continue to use conservative assumptions when underwriting new potential acquisitions. Depending on the market and property, we may decide to further adjust vacancy, bad debt, rent growth, and renovation premiums to more accurately reflect the recovery of the markets.
So yeah, just– not just continue to underwrite deals the exact same. So sure, you can be a conservative underwriter now, but the conservative underwriting from a year ago might be considered aggressive underwriting in three months from now, especially if vacancy is really low or bad debt is really high, rent growth is really low. So just make sure you’re staying up to date on the market vacancies, the market bad debt rates, and the rent growth projections, so when you begin to look at deals again, you are not just using the same standards as before, because those might be out of date, or are most likely going to be out of date. Back to the blog post.
Finally, for the investments we’re looking at, we have not changed. These Class B assets in Class B neighborhoods have historically shown to withstand recession pressures best. With median household incomes in the $80,000 range, our tenants tend to not be the first hit when economic downturns arise. They have savings and can withstand a short period of uncertainty. If those economic pressures spread and begin to affect our tenant base, it is also affecting the Class A tenants. At which point we get the stepdown effect. When we lose tenants, we are gaining the tenants coming from the Class A properties, since a Class B property has many of the same amenities as Class A – pool, workout facility, in-unit laundry – and are still located in good school districts and near employment bases. These step-down tenants do not need to make as big of a lifestyle change, while saving money on rents.
So what he’s saying here is that if you’ve got Class A, Class B, and Class C… Let’s say, everyone is financially impacted by some events like the coronavirus. Then the people who are Class A are no longer gonna be able to afford Class A, so they’re gonna have to be forced to either stretch themselves to continue to pay rent on their Class A, or take a property that’s maybe not as new, but still has all the same amenities as their Class A property, but the rent is lower and more manageable for them. So they decide to move in the Class B property which is the property that Ashcroft Capital holds.
Now, the people who have a Class B are also financially affected, but the change from Class B to Class C is a lot different than the change of Class A to Class B. So you’re more likely to get a higher percentage of people going from A to B, then you would from B to C, depending on how large of a financial impact it is. But even if the percentages are the same, the people that you lose that go to Class C properties, you’ll gain the same amount from Class A properties. Alright, so that was question number one. Back to the blog post for question number two.
“With all the uncertainty, how are you protecting my investment?” It starts with our conservative underwriting. Then we take it a step further. We run a detailed sensitivity analysis to understand how far off we can slide on rents, occupancy, and cap rates. On a typical deal, our breakeven occupancy in NOI is in the high 60% to mid at 70% range. When looking back at previous recessions, these markets’ occupancy rates bottomed out at 87%-89%. This allows us a certain level of comfort and certainty to maintain positive cash flow and distributions, thereby allowing us to ride out any downturn and never forcing a sale.
So I think that plenty of investors know what the breakeven occupancy is. That is the occupancy rate such that the NOI is equal to the debt service. I think letting them know what that is will relieve a lot of stress or uncertainty that they have about you losing their money… Because if you tell them that, “Hey, we can cover our expenses all the way down to a 65% occupancy rate. In the past recessions, the occupancy rate has never dipped below 85%. We’re always going to be able to cover our expenses, unless something insane happens that’s never happened before.” And then you can show them, “Hey, our current occupancy is this. Our trending occupancy is this, and our current occupancy is 88%. Our trending is 88%, breakeven occupancy is 65%. So you don’t have to be worried until you see occupancy rates in the low 70%, and then it might be time to panic.” I mean, obviously don’t say that, but that’s something in their minds. It’s like, “Oh, okay. Well, breakeven occupancy (explaining to them what that means) is 66%, and the current occupancy rate is 88%, and oh, in past recessions it has never dropped below 85%. So okay, I’m more confident in your ability to protect my investment.” Back to the blog post.
“What are your thoughts on how things will play out?” We do not have a crystal ball, but we do have data from the 2008 recession, which was not only kicked off by the credit crisis, but additionally, we had the H1N1 global pandemic spreading in the spring of 2009. Multifamily as an asset class faired the best of all real estate during the last recession. After their grocery bill, the second bill consumers pay is rent. In the near term, we understand that consumers and our tenants will feel some pain, as everyone is, and we are adjusting our underwriting in assets to account for this with increased vacancy, bad debt and lower market rents. So I’ve already talked about that in previous answers.
Last question is, “Is real estate a good investment in these uncertain times?” We continue to be bullish on multifamily real estate. While people may choose to not open a new retail store or expand their company, needing more office space, people will always need a place to live. When we provide a clean, modern space with all of the amenities of the newly built complex, but at 30-40-50% less in monthly rent – compared to Class A, he’s talking about – we will continue to see strong leasing momentum. Additionally, we are not relying on market appreciation for our investments. We view each property as a standalone business; one which we know how to grow income, regardless of the market cycle. We can add more income by implementing our value-add investment strategy and force appreciation. And that stronger income stream will always have a value to a future buyer, even if the cap rates relax.
So here’s one of the three immutable laws of real estate investing – don’t invest for natural appreciation. So if you invest and assume that cap rates are just going to keep going down, then cap rates go down, [unintelligible [00:17:25].15] to the same value goes up. Well, once cap rates don’t go down anymore, then your projections are way off.
On the other hand, the value-add business model is about forcing appreciation by focusing on the other variable in the equation, which is income. So rather than assuming that the cap rate’s gonna keep going down, the cap rate is kept the same, or in fact even goes up, but the income goes up through the value add program.
So again, as I mentioned earlier, sure, there’s gonna be an increase in vacancy, bad debt, but all those things are assumed based off of the current market and the projections for the market. So using those, you determine, “Okay, well, I might be able to invest $8,000 per unit to increase rents by this much money.” Obviously, the expenses might be a bit higher, but you’re still increasing the income.
As we’ve mentioned, that stronger income stream will always have a value to a future buyer, so even though the cap rates go down – so people are gonna want to buy a property that the income is going up, as opposed to from an owner who just was betting on the cap rates going down.
Basically, what he’s saying is that as long as you’re doing what you’ve already been doing, if you’re underwriting conservatively and not attempting to gamble and buy on natural appreciation, then it might make sense to eventually, buy more properties in the coming months. So again, if you want to read that in full – I basically read it in full – but it’s Coronavirus and Commonly Asked Passive Apartment Investor Questions. I think that me reading it and expanding on it a little bit more, I think this episode will be valuable enough by itself, as opposed to having to read the article.
So make sure you guys check out some of the other Syndication School episodes we have about the coronavirus; these are the more recent ones. We’ve also got a coronavirus landing page. It’s joefairless.com/coronavirus. You can check out our blog posts. Syndication School of course at syndicationschool.com. We’ve got free documents on there as well. Thank you for listening and I will talk to you soon.