The Plan—Assessing the Strategy Behind the Investment

August 17, 2024

This is Part 2 of a four-part series exploring the 4Ps Framework for Evaluating Real Estate Syndications. For a complete guide, including a glossary of terms and a cheat sheet, download our free ebook: The Apartment Investor’s Guide.

Why Focus on the Plan?

A meticulously crafted plan can be the difference between a profitable investment and a financial misstep. It’s not just about having a plan but having a plan that stands out and effectively mitigates risks while maximizing returns. Here’s how to evaluate the strategic elements of a real estate syndication.

Competitive Advantage: Seeking Unique Edge

Identifying sponsors with a true competitive edge can lead to outsized returns (alpha). You want to ensure the operator has a unique strategy and deep expertise in the relevant market and asset class.

Unique Operating Advantage: Look for operators with specialized strategies such as unique tax benefits, renovation expertise, or exclusive access to deal flow. A proven track record of creating value with these advantages is a strong indicator of a well-developed plan.
Deep Market and Asset Class Expertise: Ensure that the operator has extensive experience in the specific market and asset class of the deal. Local knowledge and targeted expertise are crucial. Avoid sponsors who are new to the market or asset class, as they might be untested and lack focus.
Multiple Advantages: A plan that incorporates multiple advantages—like unique strategies to increase NOI, favorable debt terms, below-market prices, or in-house property management—is more likely to succeed.

Red Flags: Be cautious if you encounter:

Generic, cookie-cutter plans with no distinctive features.
Unclear or overly optimistic exit strategies.
Operators who lack focus on asset management or are unfamiliar with the market.

Conservative Assumptions: Avoiding the Overly Optimistic Projections

Projections are only as reliable as the assumptions they are based on. Ensure that the assumptions used in the plan are realistic, especially concerning rent growth, exit cap rates, and expense increases.

Annual Rent Growth: Aim for conservative rent growth assumptions, ideally under 3%. This should exclude any temporary boosts from value-add initiatives or below-market rents.
Exit Cap Rates: The exit cap rate should be higher than the entry cap rate to account for potential valuation changes. Look for an exit cap rate that exceeds the entry cap rate by 50-100 basis points unless the property was purchased significantly below market value.
Appropriate Expense Growth: Ensure that expense growth assumptions are reasonable, typically around 3% or more. High increases in recent years should be factored in, particularly for insurance and property taxes.
Yield on Cost: For new developments or heavy value-add projects, aim for a yield on cost of over 7%. This metric provides a more accurate picture of potential returns compared to IRR alone.

Red Flags: Watch for:

Low projected exit cap rates that could distort returns.
Inaccurate expense projections, such as those below 50% of revenue, potentially due to tax abatements.
Lack of detailed renovation scopes, which might indicate unrealistic projections.

Margin of Safety: Building in Protection

A key principle from Warren Buffett is investing with a margin of safety, which includes having safeguards to protect against potential mistakes. While risk can’t be eliminated, it can be mitigated.

Strong Cash Flow: Ensure the property generates positive cash flow from day one. Aim for a cash-on-cash (CoC) return of 7-8% or higher, with at least 6% in the first year.
Solid Stress Test Performance: Breakeven occupancy, the rate at which the property covers all expenses, should be below 75%. Request a sensitivity analysis to see how changes in key assumptions affect the IRR.
Undermarket Price or Rents: Purchasing below market value provides a cushion if valuations drop. Undermarket rents allow for easy NOI boosts with minimal risk, provided the renovation requirements are manageable.
Adequate Cash Reserves: Reserves are crucial for managing unexpected expenses. Aim for reserves of 5% of the purchase price, plus an operating budget of $250 per unit.

Red Flags: Be wary of:

Plans where too many variables need to align perfectly for success.
Low margins of error in stress tests, indicating insufficient safeguards.

This concludes the second part of our series on the 4Ps Framework for Evaluating Real Estate Syndications. Stay tuned for the next article, where we’ll explore the third P: Price & Debt—how to assess the financial aspects of the investment. For the full guide, including a glossary and cheat sheet, be sure to download our free ebook: The Apartment Investor’s Guide.