The Price & Debt—Assessing Value and Risk in Real Estate Syndications

August 17, 2024

This is Part 3 of our four-part series on the 4Ps Framework for Evaluating Real Estate Syndications. For the complete guide, including a glossary of terms and a cheat sheet, download our free ebook: The Apartment Investor’s Guide.

Why Focus on Price & Debt?

Price: Evaluating the True Value

The price you pay for a property is fixed, but its implications for your investment can vary significantly. Paying too much can strain the business plan, while buying below market value can offer protection and upside potential.

Attractive Purchase Cap Rate: The capitalization rate (cap rate) measures a property’s annual net operating income (NOI) against its market value, giving an indication of value and potential return. Look for a higher cap rate, as it suggests better returns and higher risk. For properties requiring heavy renovations, include projected capital expenditures (CapEx) in the purchase price for a clearer value assessment.
Purchase Cap Rate vs. Market Cap Rate: Ensure the purchase cap rate is higher than the general market cap rate. A lower purchase cap rate compared to the market average may indicate overpayment. Compare the purchase cap rate to historical averages over the past 5-10 years for better context.
Favorable Sales Comps: The operator should provide sales and rent comparables (comps) for similar properties within 1-3 miles. Verify that the price per square foot is comparable or lower, and check rental comps for potential rent increases or risks of overpricing.

Red Flags: Watch for:

Unexplained discrepancies between trailing 12-month and first-year cap rates.
Historically low cap rates that may suggest purchasing at the peak of the market.
Overpriced rents that could inflate the property’s valuation.

Debt Risk: Navigating Financial Obligations

Debt is a major factor in real estate investments, and its structure can either enhance returns or lead to significant losses. Ensuring the property can cover its debt obligations is essential.

Positive Leverage: Check for a positive cap rate spread, where the cap rate should ideally be at least 1% higher than the interest rate, with 2%+ being ideal. Negative leverage adds excessive risk and depends heavily on rent growth to justify the investment.
Conservative Debt Structure: Aim for long-term, fixed-rate debt with terms exceeding the hold period by 1-2 years. While longer loans might come with high prepayment penalties, they offer stability. For short-term holdings with floating-rate debt, ensure the operator secures a rate cap to protect against rising interest rates, although this protection has limits.
High DSCR and Low LTV: For multifamily properties, target a Debt Service Coverage Ratio (DSCR) of at least 1.3x to cover debt obligations comfortably. Maintain the Loan-to-Value (LTV) ratio under 65%, or up to 75% if preferred equity is involved.

Red Flags: Be cautious if you encounter:

Variable rate debt without a rate cap.
Business plans that rely on refinancing.
DSCR under 1.2% or LTV over 80%.

Capital Stack Position: Understanding Risk and Reward

The capital stack outlines the order in which different types of investors are paid. Knowing where you stand in this stack is crucial for understanding your risk level.

Position in the Capital Stack: Equity investors, such as Limited Partners (LPs), are typically last to receive distributions and face higher risk if the property underperforms. Be aware of any mezzanine debt or preferred equity, which can alter the capital stack and should be factored into the Combined Loan-to-Value (CLTV) ratio along with commercial debt.
Compounding Risks: Mezzanine debt or preferred equity combined with high CLTV or other risks—such as inexperienced operators, low cash flow, variable rate debt, or negative leverage—can increase potential losses. Ensure the deal doesn’t place undue risk on equity investors.

Red Flags: Watch for:

High CLTV ratios that increase risk.
Preferred equity with takeover rights or decision-making control that could affect your investment position.

This concludes Part 3 of our series on the 4Ps Framework for Evaluating Real Estate Syndications. Stay tuned for the final article, where we’ll explore the fourth P: Property—how to assess the market, location, and competitive supply. For the full guide, including a glossary and cheat sheet, download our free ebook: The Apartment Investor’s Guide.