Three Mistakes Deal Sponsors are Making Late in the Real Estate Cycle
It’s not 2012 anymore. Deals these days are thinner than they once were. Some are perilous and to be avoided at all costs. Here are the mistakes we’re observing currently that are being made by some deal sponsors.
Paying Too Much
How can an investor know if the deal sponsor is paying too much for a deal? Knowing the capitalization rates of recently closed, similar properties is a start. This information can be provided by a commercial brokerage and is easily accessible. The capitalization rate, (cap rate), is derived by dividing the net operating income, NOI, by the acquisition price. For example, suppose a deal being offered for $26mm has a stated net operating income of $1,440,000 per year. The cap rate on this asset would be 5.5%. If other similar assets are trading at 5.7-5.8% in the submarket, then you know you’re paying a premium. The deal sponsor’s job is to find out why, or negotiate down the price. In any case, you need to dig deeper than the cap rate. As previously stated, your diligence has only just begun. The rent rolls and the trailing 12-month, (T-12) statement will give you a better handle on the makeup of the Operating Income and Expenses. It’s typical for the T12 and the proforma included in the Offering Memorandum (OM) to be wildly apart. But the bid should be pegged to how the asset has actually performed instead of how it could perform. Deal sponsor should not take the proformas in the OM as their own, but should run their own numbers. I prefer for the deal sponsors proforma to be more conservative than the sellers representation.
The investor will want to examine the rent projections in the deal sponsors proforma over the life of the deal. What improvements is the deal sponsor going to make to justify higher rents for the units? Are those projections in line with the market? What is the assumption of annual rent inflation from year to year after the units are upgraded? 1%?, 3%?, or more? This late in the cycle, many deal sponsors are getting carried away if they’re expecting 3-5% year-over-year rent rate increases. The higher that assumption, the more risk you carry as an investor.
Doing Deals Just to Do Deals
Many deal sponsors carry a lot of overhead. There is also the temptation to continue to feed investor appetites. But this is not always a good thing. There are good deals out there in every stage of the market cycle, but late in the cycle the amount of mediocre deals increase dramatically. Some deals sponsors will accept mediocre deals because of the generation of fee income. There may not be anything wrong with this as long as the deal sponsor communicates that the expected returns will be lower than previous opportunities. In a market where capital has no good place to live, such deals may be the only alternative, but mediocre deals are thin deals and carry increased risk to capital if the business plan doesn’t pan out.
Not Listening To Investors
Late in the cycle the deal sponsor’s tendency can be to get comfortable. If they’ve had early and mid-cycle success, there is a temptation to lose discipline with how they communicate with and relate to investors. Some deal sponsors can get downright entitled. It’s important to always treat investors as the most important members of the team. They are the ones taking risk along with the sponsor, so they deserve respect and excellent communication every step of the way. Deal sponsors can become less transparent over time and fail to keep up with regular communications. This can be especially true of the sponsors are not producing deals. But investors still appreciate hearing what the leaders of the business are thinking. If the sponsor is on the sidelines because there are few opportunities, investors would like to hear that. Transparency is something investors want to see. They will lose trust if it’s not there.
These are just a few mistakes deal sponsors can make late in the real estate cycle. There are a lot more, of course. A good deal sponsor will remain committed to their principals regardless of where they are in the business cycle.