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In multi-family investing, leverage is good. Max leverage is bad (and potentially ruinous) imho.
Here are some of my thoughts on how we (sub-institutional scale multifamily) construct our capital stack.
Here are some of my thoughts on how we (sub-institutional scale multifamily) construct our capital stack.
I am seeing more and more deals being pushed on pro-forma equity returns AFTER being levered up at very low interest rates. Broker-speak for why you should pay more because rates have fallen.
One of the reasons we underwrite to unlevered returns "UYtC" (informed by the rate environment), is because you can achieve the same levered equity returns with less risk (less leverage).
Let's say you are looking at deals to stabilize with a 10% cash on cash return (pretty good!) and you run the numbers on Deal B with a 5.75% UYtC and a 9.7% stabilized levered yield with 124% Debt Service Coverage (DSCR). Not bad.
If you can get to your return threshold with cheap debt, what is so bad about that?
I would argue that focusing on UYtC and a spread above your debt constant is a more robust way of underwriting. We strive to find deals that can stabilize to a 100bps spread to debt constant.
I would argue that focusing on UYtC and a spread above your debt constant is a more robust way of underwriting. We strive to find deals that can stabilize to a 100bps spread to debt constant.
Deal B therefore gets tossed in the "too expensive" pile for me (<50bps spread). I keep looking until I can find a deal like Deal A, where I am achieving the same levered yields as Deal B (9.7%), but with much less leverage (150% DSCR vs 124%).
I am significantly more comfortable with a debt load of 150% DSCR, 79% LTC and 70% LTV than I am with 124%, 88% and 84%. Freddie SBL is effectively forcing our hand towards conservatism with new underwriting limits on cash out refis of 130%/75% LTV.
But, of course there are other sources of perm debt that don't carry FRE's limits. We just refi into Freddie perm debt on most of our deals.
I have been underwriting deals to a stabilized cap rate (including purchase, closing and rehab costs in the denominator) for years, but h/t to @moseskagan for adding the spread to debt constant to my underwriting. A very powerful twist.
If rents permanently fall 13% (a bad, but not impossible scenario), the DSCR for Deal B falls to 100% and you are barely making enough to service your debt. Under Deal A, the same rent decrease would still carry a DSCR of 121%. A sizeable cushion.
Our entire business is built around generating outsized returns THROUGH THE CYCLE, while never losing money on a deal. I suspect I will lose money at some point, but I will doing everything in my power to avoid it. The quickest way to lose money is to over-lever.
Specifically, we look at a ton of deals for each deal we do (generally 100:1). We keep overhead down which means I am not doing deals just for the fees. Our motto is "only do great deals" ex-ante.
Less leverage means better returns during down times and lower (but still great) returns during boom times. Debt is Beta, not Alpha.
This is just the biz model that works for us. I am not demeaning different approaches or underwriting that optimizes for levered yields, IRR or MOIC. In fact, I welcome divergent views, as that is how I think we all learn best.
Literature on optimal capital structure is fascinating to me. The thing that gets lost in private RE, with no liquid equity capital market, is that your cost of equity goes up as your leverage goes up. I don't think GPs or LPs fully consider that.
https://www.investopedia.com/terms/o/optimal-capital-structure.asp#:~:text=What%20Is%20Optimal%20Capital%20Structure,minimizing%20its%20cost%20of%20capital.&text=However%2C%20too%20much%20debt%20increases,on%20equity%20that%20they%20require.
https://www.investopedia.com/terms/o/optimal-capital-structure.asp#:~:text=What%20Is%20Optimal%20Capital%20Structure,minimizing%20its%20cost%20of%20capital.&text=However%2C%20too%20much%20debt%20increases,on%20equity%20that%20they%20require.
