March 11, 2021

JF2382: Cap Rates, Waterfalls, And Preferred Returns | Actively Passive Investing Show With Theo Hicks & Travis Watts

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Today Theo and Travis will be answering the podcast listeners’ questions. They cover the topics of cap rates and return split structure. Even though some deals may look great on the surface and offer you great returns, you still have to do your due diligence and make sure that you know what you’re getting into. Theo and Travis provide examples showing how easily the numbers can be skewed or manipulated when it comes to projected returns.

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Theo Hicks: Hello Best Ever listeners. Welcome to another episode of the Actively Passive Investing Show. As always, I’m here with Travis Watts. Travis, how are you doing today?

Travis Watts: Hi Theo, I’m doing great. Thanks.

Theo Hicks: Yep, thanks for being here. Today, we are going to answer your questions. That’s right. We are now accepting questions from the Best Ever listeners. We received a few questions and we’re going to answer questions that were submitted by John this week. John, thank you for submitting those. As you can tell by the title of this episode, we’re going to be talking about cap rates, waterfalls, and preferred returns. Before we answer those questions, Travis, do you want to talk about why we’re talking about these specific topics?

Travis Watts: Yeah, I think you did a good job covering it. I think the bottom line is in the last three, four episodes, or so we’ve been opening up the ability to pre-submit your questions to us. We’ve been doing our best to keep up and try to do those either on a 60-second clip or on our episode. I thought you know, why don’t we just make a full episode of just questions that have come in over the last week. We won’t be able to get to them all, this is only a couple, but I wanted to dive in because I thought these are really great questions. So that’s kind of the backstory. Anyone who wants to submit a question, as always,; submit any questions you have and we’ll do our best to address them or at least to email a reply if we can’t do that. So… Happy to do that.

I’ll just dive into question number one. I thought this was good. I want to paint this picture a little different than anything I’ve ever heard myself on how this is explained. The question is, how important our entry cap rates versus exit cap rates in underwriting? That’s a pretty big question, so I wanna tackle that.

I guess let’s first start with anyone that may not be familiar with what is a cap rate. I’ll give my quick and dirty explanation of it. If you paid all cash for a property, you had no debt, no leverage, no mortgage, that’s your approximate yield or cash flow on the property. If you’re buying a five cap million-dollar property, you pay a million dollars cash. After you pay your operating expenses, you might expect somewhere in the ballpark of $50,000 per year in cash flow. That’s a five cap. I did want to bring up a visual for anyone who’s tuning in on YouTube. Actually, I’ll get to that in just a second.

Let’s take a couple of different parallels. I like to sometimes use stocks as an alternative example, or maybe bonds even. We’ll start with bonds. So if I buy a bond, and I forget what the par values are, if they’re $100 or $1,000. It’s been a long time since stocks, bonds, and mutual funds for me. But let’s say it’s $1,000. I buy this bond and let’s say for example purposes interest rates are at 5% today. I wish they were; they’re not. But if they were. So if the treasury is at 5%, I’m buying a bond at 5%, and then interest rates drop to 4%, for example, the price of my bond is going to go up. I’ll use my arm as that example. So bond prices go up, that means interest rates came down, interest rates go up, that means bond prices went down. So why is that? Well, because I own a bond that has a 5% coupon attached to it, or yield. In today’s environment, if you go shopping for bonds you’re only going to find 4%, for example. Someone is willing to pay more for my bond because it has a higher yield. But ultimately, what’s happening is that’s going to shift it down to the current yield. So if my bond goes to $1,200, for example, someone pays that, they’re ultimately going to have a 4% yield, because that’s how those numbers work.

Now, let’s use stocks if that was a little bit confusing. I like to think of dividend-paying stocks in parallel for this example. So you have a dividend payer stock, $10 per share; the annual dividend is 60 cents. That equates to a 6% annualized yield on the stock.

So let’s say the market rises and we have a really big bull run, now that stock that was $10 a share is trading at $12 per share. But if this happened in a short timeframe, they may still be paying a 60 cent dividend annually. If that’s the case, then your yield just dropped from 6% down to 5%, because if you run the numbers, 60 cents divided by 12, you get a 5% yield. So same type of inverse relationship is all I’m trying to point out.

And then to that point, if you’re joining us on YouTube, this is from the Federal Reserve Bank of St. Louis and CoStar data, just so I’ll get that out of the way. This is US multifamily cap rates and the spread between treasury yield, which is basically interest rates, and then the cap rates on multifamily. You can see from 1981, which is where this chart starts, all the way up until about 2001 and 2002, we hovered around an 8% cap rate on multifamily nationwide as an average. Since 2002 it’s just gone down, down, down, and down, as interest rates have as well. So they are correlated. That’s the point I’m trying to make. We’ve basically halved the cap rates over time over the last 20 years or so.

What point am I making with that? At the end of the day, back to the question, “How important are entry cap rates versus exit cap rates and underwriting?” the way I see it as a limited partner, as an investor, or as an active real estate guy, all I’m trying to do is somewhat be conservative and predict the future. As we all know, things have cycles; the stock market has cycles, the bond market, the debt markets… Listen to Ray Dalio speak to this, he’s an incredible source of knowledge on cycles in general. But the fact is, we’ve been in a downward cycle for a long time. So what is the probability or likelihood –this is what you have to ask yourself– that maybe interest rates start to reverse and come back up? When is that going to be? If that happens, you can clearly see that cap rates are going to be associated with that.

We may go to an environment where today multifamily is at 4% or 5% cap rates, where now we start up-ticking again slowly, probably, hopefully… But to five, then six, then seven, etc. to kind of normalize. This could take decades, just to be clear. However, when you’re underwriting a deal in multifamily, you’re probably going to be in this deal for many years. So to me, it’s important to think ahead. Nobody has a crystal ball, nobody can predict the future, but what you can do is be conservative and say “Yeah, I see this downward trend here, and cap rates are at 4.5% or 5% today, so I’m just going to go along with that and say they’ll be 3% when I sell.” But that’s being awfully aggressive.

Theo and I talked about a story on the last episode of a syndicate group I was watching, I was vetting their deal, and that’s exactly what they were doing. They were saying “We’re buying at a five cap, hopefully, we’re going to sell this thing at a four cap, and these are our numbers.” The numbers looked incredible, and hopefully, they can pull that off. But what happens if it goes the other direction on them? Those returns are going to get halved. It’s going to look very ugly and they’re not going to hit their projections by any means.

So when you’re underwriting –we’ve talked about this a lot– if you’re buying something at a five cap, holding it five years, do a five and a half cap, maybe a six cap upon exit in your underwriting, just to be conservative. That’s the only point I was making with the chart here.

So to that point, yes, they’re very important, but it’s a lot to do with being conservative, and it’s a lot to do with your assumptions and just trying to predict the future as best we can as real estate professionals. So with that, I know it’s a long-winded question number one. Theo, do you have any thoughts on that question?

Theo Hicks: Yeah, super-fascinating. Thanks for sharing all that. Obviously, I agree with you because we talked about this multiple times… Making sure that the exit cap rate assumption is higher than the entry. Another way to look at it as well, at least on the front end, is that when you’re buying a deal, it’s obviously better to buy it at a higher cap rate than the market is. Because if I buy it based off of the current net operating income and the purchase price at say a 6% cap rate, but similar properties in the market are trading at a 5% cap rate, that 1% is basically just free equity I’ve created at purchase. So it’s good to know also what the entry cap rate is based off of the purchase price and the NOI versus the market cap rate.

Obviously, the opposite would be a problem. If the market is at a five, and they’re buying it at a four, that would be an issue. I wish we had a calculation, but if you just take a $500,000 NOI, and you just change the cap rate by like 0.1%, the value of that property changes so much. So if you do that calculation, it’ll show you why these are so important, especially the exit cap rate. Because changing the exit cap rate by a couple of decimal points might make a deal look really, really good… As opposed to just being an okay deal.

So as a passive investor, you don’t need to know every single aspect of the underwriting, but these cap rates, since they have such a dramatic impact on the value of the property, you want to understand how they’re coming up with these numbers.

Travis Watts: And that’s back to that story of that syndicate group, buying at a five, projecting a four. That’s just the simple way as an LP, as a passive investor, something to look for. We talked about red flags, we talked about due diligence, and underwriting, and whatnot… Just keep an eye out for that. Always ask. In that instance I shared on the last episode, they didn’t announce that in their webinar at all. They completely brushed over the entry and exit cap rates completely, and just showing folks “Oh, we’re going to get this 20% return” or whatever it was. It sounded great until I asked the question and I realized what happens. So… Red flag. Something to be aware of.

Theo Hicks: Exactly. So that was question number one. Question number two is how important are preferred returns versus having a straight waterfall split of 70/30. So we’ll define these terms really quickly. A preferred return is basically a threshold return that the GPs offer to the past investors. If they’re offered an 8% preferred return, then they get the first 8% of the ongoing cash flow. Then once the preferred return threshold is achieved, then the remaining money is split based off of the next step in the waterfall.

Whereas the other option which is a straight 70/30 split, there is no threshold return for passive investors. It’s just every dollar that is output as profit is split, in this case, 70/30 or 50/50. Then another term he threw in there was waterfall. Really, a waterfall is just like a written explanation of how the profits are distributed. So the first part of the profits go to the debt, and the next part of the profits go to the preferred return, and the next part might be unpaid preferred return, and then it might be the split, and then once it gets to a certain IRR, the split my change to something else. So these waterfalls can be pretty complicated, or they can be as simple as just “Pay the debt and then 70/30.”

Why is it important to have a preferred return? Well, it’s kind of like a protection for the passive investors and it promotes an alignment of interest between the GPS and the LP. If I’m investing in a deal and I know that I get the first 8% of the profits before the GPS gets paid, then they’re probably going to make sure that deal’s cash flow is 8% so they make their money… As opposed to if they just get paid regardless if it’s 1%, 2%, 3%, 4%, up to 8%, then the alignment of interest is a little bit different and I’m less protected, in a sense. I think it’s really as simple as that. I think it’s as simple as just an extra layer of alignment of protection, an alignment interest for the limited partners, and then knowing that “Hey, if this deal cash-flows 8% or lower, the GP is not going to get a portion of the profits. I’m going to get that.” I think it’s as simple as that. Travis, what are your thoughts?

Travis Watts: Yeah, it is kind of quite that simple. To your point, there are no guarantees with investing. This to me is kind of the next best thing. It’s saying, “Well, hey, look. I’ll give you the first 8% of a deal or whatever. 100% goes to you first, before I even start pulling out of it or splitting anything.” I like that incentive. I’ve done both as a limited partner, I’ve invested in both structures. I’ll tell you, part of my criteria today, 2021, is to always have a preferred return or what some groups call a coupon. The difference is really if it’s a limited partnership structure, an LLC structure, but not to get long-winded with that…

I did partner years ago in a deal, no preferred return, straight split, like exactly this question. I don’t know – call it coincidence or what have you, they stopped distributions for (in my opinion) not a great reason. I felt like it was just because they didn’t have to. There was no obligation, there was no pref, no expectation, whatever. So it baffled me. It’s like, “Why would you do that? You’re obviously going to turn off a lot of your investors by doing that.” But rightfully so, they did it.

For what it’s worth, I just feel like of all the deals I’ve done with preferred returns, I feel like –to your point Theo– it’s the GP saying “We better make sure this deal is performing and we better make sure our investors are getting paid, or we’re going to have some problems on our hands.” I just feel like it’s not even an alignment of interest, it’s putting the LPS first, which maybe seems a little selfish… But hey, you know, we’re the ones taking most of the risk anyway. So for what it’s worth, yeah, that’s the bottom line. It’s an alignment of interest, it’s something I look for. It’s something that everyone listening should put in their criteria, either way. I prefer just a straight split structure, I prefer having a preferred return. So those are my thoughts on it. Pretty straightforward. I think.

Theo Hicks: There’s one thing that I just thought of that I think confuses some people. I think this is a good spot to talk about. That’s the difference between when you’re reviewing a deal, the difference between the preferred return and the cash on cash return percentage. So you’ll see a deal where, for example, the overall preferred return is say 7% to you as an investor. Then you look at the investment summary and you say “Oh, hey, why are they saying that I’m only getting 5.8%, or 5.5%, or 5% (or whatever) cash on cash return year one? And then why is it at the end of the deal, the cash on cash return is 20%? I don’t get that, what’s the difference between that cash on cash return and the preferred return?” The preferred return is just again, a threshold. It’s not you’re guaranteed to get 7% forever and then that’s it, that’s all you’re going to get, there’s nothing else. That’s just like, “Hey, that’s the threshold. Up to that point, you get the cash flow. Then above that, it gets split. So if the deal cash flows below the preferred return, then you’re going to get whatever that cash flow is.”

Usually that difference between the preferred return that you’re offered, and the cash on cash return that you actually receive, that will typically accrue and be paid out at some point during the deal. It kind of varies from sponsor to sponsor. Let’s say that year two it’s 7%; well, then you get 7%. Let’s say year three it’s 8%, so you’re going to get your 7% plus whatever the split is of that 1%. You might get 0.77% percent, a 70/30 split. Overall, over the lifetime of the deal, all those percentages will be averaged to get you what your overall cash on cash return is.

So kind of overall, the cash on cash return is just based off of what you actually get, and the preferred return is just saying, “Hey, here’s the threshold. If it’s below this, you get all of it. If it’s above this, then you get up to that point, and then a split of what’s left.”

Travis Watts: Exactly. And there are different ways to catch up with a pref, while we’re on this topic. Ideally, how you’re going to catch up on a pref in your example, Theo, is if your property actually produced 5% in a year, but you have a seven pref – well you’re behind; you didn’t get the full pref. Ideally, through the performance of the property, you’re going to be able to catch that up. As rents and cashflow increases, you can eventually catch everyone up. If you can’t do that, you can catch up a pref through a refinance, for example, if there’s some equity to be had. Extract some of that, pay everybody up to their pref, maybe a little more, who knows, return the capital, etc. If you can’t do that, it can come from the sale of the property.

I had this happen – a property really went sideways in terms of the projections, but there was a good amount of equity in it. So when we sold, that pref got caught up first. So all the LPs ended up getting that pref and then we did a split on top of that. But unfortunately, we had to wait. So yeah, a lot of folks that are especially newer, are confused when they see a 7% pref, that “Oh, this thing is just 7% cash-flowing for five years.” That’s really not how it works. It could be below, it could be above, it could be at… It’s going to be all over the place. But pay attention to that in the underwriting when you see these deals, anyone who’s an LP or a passive investor.

What I see a lot of times is a deal will pop up in my email from some sponsor, and it’ll say “Average cash flow 9.5% annually.” I’ll think, “Wow, that’s incredible.” Then I’ll look at the breakdown, it’ll be like 5% year one, 7% year two, and then they’ll bump away high like 13% or something. What they’re doing is they’re projecting a refinance, they’re trying to manipulate the numbers,  and they’re trying to spin this thing off to the illusion that it’s just the 9% cash-flowing asset. It is not, by any means, that. So it’s important to dig a little deeper, ask the questions, do your due diligence, etc.

Theo Hicks: And we’ll do a show, because I like it when I go into more detail. We’ll do a show where we talk about the different returns that are offered. I don’t think we’ve done one yet. Because there are different cash on cash returns, equity multiples, IRRs, all this fun stuff. I think that could be a full show.

So we’ll stop there with answering those two questions. Again, if you want to have us answer your questions, either on the main show or on the 60-second question YouTube videos that we do, you can submit your questions to You can send one question or a list of questions, whatever you want. So, Travis, is there anything else that you want to mention before we sign off?

Travis Watts: I don’t think so. I think we hit it. So thank you guys for these questions and keep them rolling.

Theo Hicks: Yep. Keep them coming. Travis, thanks again, as always, for joining me today. Best Ever listeners, thanks for tuning in. Have a Best Ever day and we’ll talk to you tomorrow.

Travis Watts: Thanks, Theo. Thanks, everyone.

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