So far in 2022 I have underwritten more than 25 multifamily deals and drove several properties. I have met with most of the major listing brokers in DFW. I also have a list of active deals and upcoming deals for Q1. From this research I want to share a few key observations about the market.
Cap Rates
Anyone in real estate knows it is a seller’s market right now. Sellers want top dollar for their property. The whisper prices for apartment deals are high. There is also a lot of interest in apartment deals, so it is competitive. When underwriting the deals at the price the seller wants, I notice the cap rates are starting to compress.
The cap rates are at a solid 4% in DFW overall and dropping. Several deals are below 4%. It is up to the buyer to come up with creative ways to reduce expenses and increase income. Luckily, the rising rent narrative will help increase the income without adding much value to a property. Rents rose double digits last year in many areas. There was loss-to-lease and 2022 might be the year that new leases catch up. I also suspect rents to rise this year as well as inflation runs hot.
Taxes
One of the biggest line items for expenses is taxes. The offering memorandum typically shows property tax consistent with where the property is currently operating at. However, if you purchase a property for a significantly higher price, taxes will go up. Many lenders will underwrite taxes as 85% to 90% of purchase price multiplied by the tax rate. If you are basing your tax rate off what the seller is currently paying, your net operating income will be off by a lot.
Taxes is one of the widest discrepancies that I have seen so far from proformas. In a seller’s market you might have to overpay for a property to win a deal. Protesting property values or trying to seek alternative ways to reduce taxes will be a strategy worth pursuing. Especially since taxes will often go up by multiple six-figures on bigger deals, taking a bite out of the cash flow.
Agency Lending
With cap rates compressing and taxes reducing cash flow, agency debt is less attractive going into 2022. Many deals do not pencil out to more than 60% leverage. A lot of deals pencil to 50% or sometimes even less leverage for what the seller is asking. It will be hard to pitch a deal to investors with low leverage because the returns will be lower. Doing a financial model with 50% leverage produces less than favorable results. Far less than what investors are accustomed to.
With this knowledge be sure to look at deals more closely that you invest in. Do your own research and investigate the story of how the deal sponsor plans on achieving their return. They might be able to achieve higher rents without doing much. To get a 15% IRR (Internal Rate of Return) and a 100% total return in 5 years the buyer will likely have to use bridge debt. There are a lot of active bridge lenders right now looking to loan against multifamily properties. I work for Old Captial as commercial mortgage broker, and we currently have over 50 non-recourse bridge lenders available.
Bridge Loans
On bridge loans you can get up to 80% leverage with a lower than 1.25 DSCR (Debt Service Coverage Ratio), which agency lenders require. This of course is riskier. The bridge lender will want to see a DY (Debt Yield) of at least 4.5% or higher when purchasing. The loan applications for many of these bridge lenders will have a springing lock box. This is an account established up front with the lender that will be used if you do not hit a certain metric. In some cases, by the end of 18-24 months if you do not have a certain DY, say 7%, then the lender will start cash management and be in control of the operating income.
It is important to execute your business plan expeditiously when using bridge financing. Raising rents will likely be part of that story.
Conclusion
The market continues to be red hot and cap rates are still compressing. It is important to keep an eye on interest rates heading into the summer. The Federal Reserve is under pressure to raise rates sooner rather than later. Be sure to have a good business plan and execute it quickly when using bridge financing. Do extra due diligence when investing in a deal that has agency debt or be comfortable with a lower return. If you need help getting financing for an apartment deal or want to discuss further, please reach out.
