Third LP Investment Pillar: Property

We recently discussed the first two pillars of the three LP (Limited Partner) investing pillars and today we’ll discuss the last - Property.

• Execution - track record and counterparty risk

• Read the article here, preferably before continuing.

• Alignment of Interests - coinvest, waterfall, and fees

• Read the article here, preferably before continuing.

• Property - valuation and business plan

As I mentioned in prior articles, the pillars are in the order that I believe you should vet a transaction. It might surprise you that the property is the last thing you look at when analyzing a deck for a commercial estate investment, but this reflects the fact that you’re not just investing in a property - you’re investing in a property **through a GP. **This is a change you shouldn’t take lightly, since you have close to zero control after wiring your money.

You’re not just investing in a property - you’re investing in a property **through **a GP.

The reason why the Property pillar is important, is that you might vet the first two pillars correctly but the investment will “stumble” due to the Property pillar.

In other words, you could find a GP that has great Execution capability (Pillar #1) and they passed all of your vetting from the perspective of Alignment of Interests (Pillar #2). Then, you decide to invest in the deal, only to find out that the valuation and/or the business plan was too lofty from the get-go. Unfortunately, I have seen this happen.

Let’s not forget that both income and the investment’s value is tied to the property itself, and although a GP can (and should) influence the trajectory of the investment opportunity, you are (at the end of the day) investing in a building.

After sharing the tweet below (true story, and unfortunately there are many), I made a meme. In the context of our topic for today - don’t forget to understand and value the property itself (the cash flow generating engine).

The below is a list of things to consider from the perspective of property valuation. For the sake of example, I will use a multifamily property in the writing below.. but of course similar (or slightly varied but equally important) questions apply throughout all asset classes.

**Valuation - **in other words, is the property actually worth what the GP is paying for it? A few specific things to look out for:

• Price:

• Take a look at the comps provided. If the property the GP is buying is the best (i.e. cheapest) comp in terms of rent and/or price per square foot, chances are you need to look a lot deeper:

• It’s very rarely the case that you’re getting the best deal that ever existed in the past few years, regardless of area or asset class. It is often the case, however, that the comps are selected to present a favorable picture (keep bias in mind - you are looking at a sales pitch).

• Needless to say, looking at price per foot is helpful, but shouldn’t be the end of your analysis but rather a reason to seek out more answers. Price per foot comps aren’t created equal and you can think always through that by looking at extremes - small buildings vs large buildings, old construction buildings vs new construction buildings, buildings with large floor plans vs buildings with tiny floor plans (while having the same number of units), and the list goes on and on.

• Remember that the price today is determined by both NOI and Cap Rate

• NOI is important to vet, since it’s typically a proforma (i.e. adjustments have been made by the GP) against the sellers trailing 12 months statements (which, again, might have a second layer of errors or adjustments). To be clear, it’s not your job to vet this at the level that a GP would.. that’s their job. However, it’s your job to vet it enough to see that the assumptions and adjustments aren’t egregious… and you can usually do that by looking at a few assumptions (as opposed to all). Over time, you’ll develop a level of trust based on a mix of honest communication, execution, transparent presentation, etc.

• The cap rate is equally important, and this can be tricky. For a few reasons.

• First, recall that a cap rate is just NOI/Purchase Price … but the NOI can be calculated in different ways. The simplest method would be to take the last 12 months of actual performance (both revenue and expenses), but this typically isn’t the case and you’ll often see an annualized T6 (short for trailing 6 months) for a property that’s ramping up (last 6 months are better than the prior 6 months) with layered on T3 expenses (again, annualized) for example. Note that this isn’t just the case for your property, but also other properties in the comps provided by the GP… so you have to be mindful of this when comparing numbers.

• Second, all cap rates aren’t created equal. They vary by asset class, risk, diversification, maturity, etc. I will write about this at length next week.

• Market analysis:

• Where is the property located? Understand the surrounding area, crime (e.g. Google helps if you type in “shooting” next to property name or address), and growth factors.

• All too often, I see decks that have macro information in the deck but it’s very difficult to apply the information to the subject property. For example, if Texas is growing as a state that’s good… but while Texas is growing as a state there might be net migration out of the particular area where the property is situated.

• With respect to market analysis, and really all implicit assumptions in a deck, be careful to not come to conclusions until the logical step is made (ideally for you, via the deck or conversation).

**Business Plan - **what is the plan for the property and what’s implied about the cash flows and returns as a result? For example, if a property will be heavily renovated:

• Since the renovation takes a certain amount of time (typically 1-2 years), the return of the deal is heavily weighted towards the backend of the project. Sometimes you’ll see cash flow in years 3-4, but it’ll be inconsequential relative to the IRR’s sensitivity to exit value (what the property is sold for)

• The topic of exit values deserve an entire post on its own, but suffice it to say that you need to be mindful of the assumptions. Broadly speaking, exit value is a function of NOI and a cap rate and both of these need to be checked to see whether they’re realistic (similar to our discussion above on the entry cap rate analysis).

• NOI could be impacted during the construction period (check that it does) due to (1) lower number of units being occupied (so that the GP can renovate them) or (2) the noise to existing tenants (people won’t pay market / have a higher probability of not being happy/leaving)

• Do the rents make sense relative to market, and can they truly be raised to the levels presented in the business plan? You can always renovate anything, but it doesn’t always make sense. In other words, it needs to be the case that renovating the property provides enough marginal returns to the LPs, when comparing to not renovating the same property. I have seen cases where the renovation didn’t make economic sense and I have also seen cases where the GP was promising to raise rents to unattainable levels (pre and post renovation).

• It goes without saying that you need to make sure that the GP has experience with the specific business plan that they’re after in your particular investment. In other words, although a GP might have a great track record in one specific asset class, you need to be cautious when assuming that this expertise will perfectly transfer to something completely new. The same holds true as a GP enters a new geography.

• How does debt play into the business plan, and what could go wrong?

• Is there floating debt that could increase expenses in the future?

• Can a maturity cause a cash in refi in the future? I’ll likely write on this in the future in long form.

• Are realistic terms being assumed at the time of the refinance? Don’t just believe that you’ll get x% of your principal out - you have to understand why the underlying assumptions make sense. I will write about this soon as well.

• Does the Sources and Uses reflect the business plan?

• If there’s a construction component, is it clear where the money is coming from and does the budget make sense?

• More broadly speaking, make sure you understand the sources and uses and ensure that it’s complete with any fees, closing costs, etc. It is very reasonable for you to understand what the flow of capital looks like.

• Hold period matters

• Note that, although hold periods (e.g. 5 years) can be extended, you should understand that and mentally be able to let go of your investment for a long time - at least as long as the hold period, and I would say it’s a good idea to assume it’ll take a little longer too

• Hold period can play tricks on IRR as well, and your multiple on invested equity (often referred to as MOIC). I’ll post on this later as well.

To recap, here are the three pillars of LP investing again:

• Execution - track record and counterparty risk

• Alignment of Interests - coinvest, waterfall, and fees

• Property - valuation and business plan

Also, as a reminder, these three pillars are independent. In other words:

• You could find an investment that scores really high on two of them, but performs poorly on the third. For examples, visit the first pillar post.

• Such an imbalance is fine, as long as you are aware that you’re taking on that additional risk and are being compensated for taking it on

• The best investments will have risks that you get comfortable with due to their respective mitigants

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