by | 04, Mar 2022

Bonus Episode: Is Your Operator Aligned With Your Investment Goals?

We’ve got another exciting bonus episode for you all this Friday!

Today I put out a video that I hope will help you gain some clarity on how to make sure your investment goals align with your operator. Is your operator, and their business model, the right match for you?

So… if you can’t watch and just want to give it a listen, then happy Friday! Here is a gift!

Let me play matchmaker for you and make sure your investing journey is a happily-ever-after scenario.

We will talk about these things…and more in another BONUS episode of Multifamily Investing Made Simple.

Tweetable Quotes:

“Understanding your risk tolerance is step one to finding the right operators to partner with you. ”  – Anthony Vicino

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five rules of investing

The Five Rules of Investing

** Transcripts

Anthony Vicino: [00:00:00] Is your operator aligned with your investment goals? Stay tuned to find out. Hey, what’s up, guys? I’m Anthony Vecino of Invictus Capital and author of Passive Investing Made Simple and the co-host of Multifamily Investing Made Simple an awesome podcast. I’m not biased. Go check it out. I highly recommend it. Ok, I’m biased. Now, before we get started, make sure that you hit that like button. Go hit subscribe so that you can be notified when we drop a new video every single week. Now, let’s get to it. How do we know if your operator is aligned with your investment goals? This is a really important question because there are a lot of ways to make money out there in real estate investing when it comes to apartment syndications and being a passive partner. There are also a lot of ways to lose money, and it’s not necessarily about how much money you make. A lot of times it’s about how you make your money. All right. So generally, when it comes to setting our investment thesis or our parameters are goals, people kind of fall into one of three buckets. Now it’s a spectrum. They’re not fully into one bucket or another bucket. And maybe not all of their investments fall into that one bucket. So maybe they want to diversify across the spectrum. But generally thinking to speak, here’s what we’re looking at. On one hand, we might be young and we might be fresh out of school, and we might be looking to generate massive returns on our equity to get that snowball going.

Anthony Vicino: [00:01:28] We’re not really interested in cash flow. We’re not really interested in tax benefits because we’re young and we need to really we don’t have any assets. We don’t really have any money to protect. So we’re going out there and trying to get that snowball going. This type of investor is probably likely willing to take on the extra risk because they have that most valuable of all assets, which is time. So if they get hit hard and they lose some money, it’s not a big deal because they have so many years to make it back up. So they’re typically looking at higher-risk investments, things that can really get that equity ball going. Now, if we fast forward into the middle years of life as we start to settle down, perhaps we have a family now we have some kids, you have more responsibilities, more bills to pay. Maybe we have a W-2 that we’ve been in for a while and we’re starting to dread. So maybe now we’re looking for ways we could exit that W-2 just a little bit earlier. So now maybe we’re looking at investment opportunities that could provide more of a mixture of appreciation or that big-equity gain and then also some cash flow because it would be awfully nice if I could get some monthly income so I can maybe separate myself from my job. Or maybe you like your job and you just want to have that extra cash flow coming in so that you can pay for vacations or other things in life.

Anthony Vicino: [00:02:39] That’s going to be a different type of investment than our young fella straight out of school right now. If we fast forward even further into later years, let’s say I am an elderly gentleman. I am fastly quickly approaching retirement. Maybe I’m five years away from retirement. I’ve been working hard my entire life. I have a ton of assets and the main goal at this point is not to lose money. I can’t lose money. It’s all about capital preservation. So the assets that I’m looking for are maybe not going to have big equity gains. Maybe they just have some solid cash flow, but more so than anything else. I want to hedge against inflation. I want to hedge against volatility. I want to hedge against potentially losing my money. I want those good, good tax benefits, too, because, you know, I’m making a lot of money at this point. You know, I’ve been working my entire life. So those are kind of three buckets that people generally fall into. Regardless of your age. Let’s take the age equation out and just say on one side, we’re looking for big equity. On this side, we’re looking for cash flow inequity and on the slide, we’re looking for just preservation. So where do you fall in that spectrum? Like understanding your risk tolerance is step one to finding the right operators to partner with you. If you’re looking for the big equity gains, then maybe you’re looking at development deals.

Anthony Vicino: [00:03:50] If you’re looking for cash flow and depreciation, maybe you’re looking at multifamily value. Add deals. If you’re looking for just capital preservation, it could just be core assets like brand new luxury class A buildings. They don’t generate cash flow, but they’re solid, right? So now once we have our investment thesis and we’re going to our operators and we’re looking at their deals, the first thing that we’re looking at is IRR. What is the internal rate of return? That’s the gold standard of return metrics when it comes to commercial real estate. Now, IRR can be a really confusing term. We did shoot a video that dives into it, so it’s going to be linked up here somewhere. Go check that out. If you’re not familiar with it. At its core, it’s all about taking into account the time value of money when we’re calculating our returns. Now, if you see returns north of 20 percent IRR, that’s a riskier investment. That’s a pretty good large return, right? So that’s going to skew maybe over here towards our investor who’s looking for more equity growth, right? If it’s more in that 15 to 20 percent, that’s a little bit more. That’s still a really awesome return, no doubt, but it’s probably a little less risky than the 20 North. Right? And then anything below 15 percent, maybe eight to 15 percent, that’s going to be a little bit more solid. So that’s number one.

Anthony Vicino: [00:05:05] When we’re talking to our operators, it’s understanding what kind of returns are you looking to generate here? Because if you’re early in the game and you’re looking for those 20 plus, it’s not going to do you any good if. The operator that you’re working with is projecting 12 percent. It’s not going to cut it. Vice versa, if you’re not, if you’re looking to not lose money and you see a return north of 20 percent of pump the brakes you might be diving into to a little bit more risk than you’re willing to take on. Now, as we’re looking at our operators underwriting their assumptions that how they generated these numbers, this is really important because numbers don’t lie, but I can make them say whatever I want. So it’s important that we understand the thought process that went behind our pro forma numbers. So if my operator is projecting twenty two percent IRR on a four-year hold, I want to know how does he like? How did he underwrite this? How did he come to these returns? Hopefully, they didn’t just come out of the sky, right? Like, there’s probably some kind of business plan behind that. So here are some assumptions that we always want to question to make sure that those return metrics are actually in alignment with our investment goals and that they’re not just being massaged to the operator’s benefit to make the deal look better than it truly is. So number one, here’s three assumptions that we want to question very closely.

Anthony Vicino: [00:06:21] We want to question rent growth expense growth, and we want to question our cap rate at disposition. So let’s take this from rent growth. Number one is when we go when we buy an asset, we do assume that the rent is going to increase over time. All right. Now, the problem that we can get into is if we assume that rent is going to grow at too optimistic of a number, and I would say in the last 10 years, it’s been really easy to generate big returns just by riding the wave of organic appreciation as a market just naturally does better, and it delivers five seven 10 percent rent increase year over year. But when we’re underwriting for our projections, we want to make sure that we’re being conservative in the assumption and a good conservative assumption on rent growth is around three percent year over year, two to three percent. That’s a solid conservative approach. Now, if we’re doing, say, a value-add deal, we’re in the first year or two, we’re going to go in and we’re going to make improvements or we’re going to make this thing better and increase the rents. You might see seven, 10, 15 percent increases in those years as we’re bringing the building up to market expectation. But in the later years of the deals, let’s say three, four, and five, we should expect the underwriting assumptions to taper down to around two to three percent as there’s no more value add to be done.

Anthony Vicino: [00:07:39] It’s already been done. Now we’re just riding the organic appreciation. So that’s number one. When it comes to rent, we assume two to three percent when it comes to expenses. We also baseline assume at least three percent increase in expenses every year because inflation is a real thing and especially in twenty twenty one twenty twenty two, inflation is real and depending on what school you come from and how you calculate it, inflation is probably well north at three percent at the moment. So in the current market environment, while we’ve been underwriting for three percent in years past, it might not be a bad idea to bump those numbers up there kind of rookie numbers. So let’s look at maybe five and seven percent expense growth expectations for the next couple of years. This is big because if you do not adequately budget for expense growth, you’re going to find yourself in an in a real tough pickle when suddenly your cash flow is being consumed by these ever-increasing expenses. And suddenly that deal that looked really great in year one suddenly isn’t quite penciling in year three. So we want to question those rent growth and that expense growth generally. I think it’s a good rule of thumb to always make sure the expenses are outpacing the rent. It’s always a good principle to assume the future is going to be worse than the present. So when things can go against us, we want to be more liberal in pushing those numbers higher when things can go for us.

Anthony Vicino: [00:08:58] We want to be more conservative and keep those numbers a little bit more subdued, and that’s where the cap rate comes in. A good friend of mine says that cap rates are like the eighth wonder of the universe, the most powerful force in the world, and it’s because the cap rate is inversely proportional to the value of the building. So a tiny tweak in the cap rate can have massive downstream ramifications, ramifications on the value of our building. If I am off by even half a percent or a quarter of a percent when calculating my exit rate on my exit cap rate, it’s going to tweak the valuation in ways that might make my numbers look drastically different than reality. So what I would like to see is every year that we hold a building, we should see at least a 10 basis point reduction or growth in cap rate. So the way to think about cap rate, remember the lower the cap rate, the more valuable our building. So a four cap is going to lead to a higher valuation than, say, a six cap. So if I go in and I buy my building at a four cap, I don’t want to assume in year five that my cap rate is going to have dropped to three percent because that’s just going to make my building look way more valuable than it might actually be. And since I don’t know what the future is going to hold, I need to project that things are going to be worse than I hope they are.

Anthony Vicino: [00:10:16] So maybe when I go to sell instead of thinking it’s going to be a three percent, I’m going to have that cap rate starting to increase 10 basis points every year. So if I hold it for five years, that’s 50 basis points. So if I bought it at a four cap, that means when I’m going to sell, I’m going to assume I’m selling it out of four and a half cap. Ok. So when you’re looking at your operator’s projections, these are things that you want to vet. You want to be very clear on what is their rent expectations, what is their expense growth expectations, and what is their cap rate at disposition? And the last thing a little bonus that we’re going to throw out there something that you want to keep in mind is what is the cash-out refinance assumption, the cash-out refinance, it’s so powerful. It’s like the super, the superweapon in the multifamily investor’s arsenal. It can boost returns by multiple percent just by factoring it in. And it’s great when it works and for every one of our deals, we strive to execute a cash-out refinance. But because we don’t know what the future is going to hold, and we don’t know if interest rates are going to be 10 percent higher than they are currently, we don’t know what the lending environment is going to look like.

Anthony Vicino: [00:11:21] We don’t want to base our underwriting assumptions on that thing having to occur. And so we want to be really conservative with our cash-out refinance and whether or not it’s actually going to occur a lot of times, what we do in our underwriting is we don’t even factor in the cash out refi. If the deal still generates returns that are adequate for your investment goals without the cash-out refinance, then you’re going to be really excited if we can actually execute it. So just the bonus thing to think about when you’re looking at the return metrics and whether or not your operator is actually in alignment with your investment goals is are they massaging all the numbers and juicing those returns by factoring the cash out refinance and really advantageous rent growth? Or they’re not factoring in expenses adequately or they’re saying the cap rate is going to continue to plummet. These are things that might point to a misalignment of your investment goals with their business plan. And so that’s going to do it, guys. Hopefully, you’ve got a little bit of value out of this. If you did do me a favor, go share it with a friend and go Share it with a family member, the guy down the street at the grocery store. I think they could all benefit. As you guys know, I believe everybody should own a piece of real estate, and hopefully, this helps you on the path to doing just that.

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