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REAL ESTATE Current real estate equity trends

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Sid23

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This was emailed to me today. Thought it would be useful to pass on.

Recent Trends in Multifamily Reposition Equity
By Steven C. Orchard & Joshua M. Roseman

While many recent news articles focus on disruptions in the debt market, it is important to note that the credit crunch has also impacted the equity market. This article summarizes current trends in the equity market; more specifically, the market for institutional joint venture equity in value-added multifamily transactions. Please note that this commentary is a broad generalization; actual treatments by equity sources vary widely.

In summary, equity standards are significantly more conservative today than they were six months ago. Marginal tightening across all underwriting metrics makes for a challenging environment. Conservatism is articulated by higher yield requirements, less aggressive pro forma assumptions and increased risk awareness. Transactions must be compelling, with strong locations, economics and sponsorship. Those seeking investors should test their models for sensitivity and stand ready to defend assumptions. Specific trends and changes in the key underwriting metrics are outlined below.

·Contribution Splits: 90% to 95% co-investment was common in early 2007. Today, 95% is rare. While 90% is still widely available, some investors now cap their contribution at 85%.
·Preferred Returns: Preferred rates range from 9% to 13%. While 8% was once typical, now 10% is more common. Transactions with special risks (entitlement, major construction, etc) may require 12%.
·Yield: Institutional multifamily investors today are looking for 18-20% overall annual yield, using the investor’s conservative assumptions.
·Profit Splits: The investor’s demands with respect to profit sharing vary widely. Straight 50/50 splits were commonplace as recently as six months ago. Today, most use a “waterfall†to subordinate sponsor equity, such as splitting 75/25 until the investor achieves a 15% return, then 50/50 thereafter.
·Purchase Capitalization Rate: Sub-5% cap rates invite scrutiny. Regardless of value-add opportunities, investors are wary of over-paying.
·Exit Capitalization Rate: Cap Rates depend heavily on location, but 7.0%-7.5% is a common benchmark. Investors look for a positive margin of approximately 1.5% between purchase and exit cap rates. 6.0%-6.5% is acceptable in prime metropolitan markets with barriers to entry, like LA, SFO or DC.
·Market Rent Assumptions: In-place and pro forma asking rental rates are aggressively tested against comparable units. Be prepared to defend a detailed comparable analysis.
·Market Rent Growth Assumptions: Investors will consider accelerated market rent growth in strong markets, but primarily focus on returns assuming 3% annual rent growth.
·Sponsorship: Attractive sponsors demonstrate prior experience with respect to market, product type, transaction size and business plan. Sponsorship is critical.
·Debt: If investors are left to establish their own assumptions on debt financing, they are usually overly conservative. Sponsors should provide qualified debt terms to avoid unnecessary penalties. Debt must be secured before investors will commit equity.
·Sensitivities: All assumptions are tested. Investors favor robust investments that can weather a storm. A transaction that works on the margins but not when assumptions are tested will generally be passed over.
·On/Off Market: Broadly marketed acquisitions are heavily scrutinized. Many believe that cap rates are increasing, and assume that aggressive bidders must over-pay by default.
 

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SteveO

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Amazing how fast the market can change.

This article is primarily relating to equity partners and project investors. It seems the experienced investors are tending toward the experienced operators. 18-20% sounds so low though. :jiggy:
 

andviv

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I take the 18-20% is referring to before-split yields, so yes, it is low. Why should I take into this investment with added risk when I can get a similar return in the market? I think this is one of the issues to attract investors given the current conditions. However, I found that investors were also 'scared' when the projections showed returns above 25%... they seemed to believe we were overstating the numbers when actually the opposite was happening.

I found interesting the changes in profit splits. I was not expecting the market to react this quickly in that way. The 15% in the waterfall approach seemed reasonable though.

Great find, thanks for sharing.
 

JScott

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Okay, I'll be the first to admit that I didn't understand many of the terms/concepts discussed here. Can someone point me to a good reference book on how equity splits in RE generally work?

What are contribution splits? What is waterfall?

Sorry, don't know where to start here... :)
 

andviv

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These are my understandings... I don't know of any book about this as I learned this by partnering in some investments and reading the contracts.

contribution splits: The money investors will put up to x% of the money needed to make the deal happen. Last one I participated in the money partners put 100% as the managing partner has an excellent, proven track record. As SteveO mentioned, "the experienced investors are tending toward the experienced operators". Maybe SteveO could provide better/correct definitions.

profit splits: How the profits will be split between the money investors and the general/managing partners

waterfall: layers of profits splits. first layer is give all the profits to the money investors until they reach a guaranteed X of return. The second layer is how the rest of the profits is split (usually 50/50)
 

SteveO

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Contribution splits has to do with partners from the equity market. This is slightly different than gathering investors for your own deals. The article as presented is discussing the changes in terms from the equity market side. These are typically deals that are greater than $10M in cost.

In this case you would find a deal and present it to an equity partner. This partner is usually defined as a company that funds apartment or commercial deals. They will scrutinize the deal. The contribution split is the percentage of the down payment that they want you to put down so you have some skin in the game. If a 10M deal requires a 2M downpayment and the contribution split is 90%, the equity group would put down 1.8M and you would need to come up with the 200K difference.

The biggest drawback to using equity partners is that they want too much of the control for the deal. They tend to favor the hands-on type of operator that will be coordinating the project on a daily basis. You must be a proven deal maker with experience for these groups to consider tossing money your way.
 

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