Today Theo and Travis will discuss the importance of thinking about the exit strategy before entering a deal. In a way, this is not the topic that gets covered often since most investors are not thinking ahead far enough. However, selling the asset is a vital part of the investment process.
Travis gives an example of how something that looks like a great buy at first can turn out to be a lemon if nobody wants to take it off your hands. And just because a property is at a great acquisition point, it doesn’t mean that you should jump into the deal.
We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting SyndicationSchool.com. Thank you for listening!
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TRANSCRIPTION
Theo Hicks: Hello Best Ever listeners and welcome to another edition of the Actively Passive Investing Show. As always, I am your co-host, Theo Hicks, with Travis Watts. Travis, how are you doing today?
Travis Watts: Hey, Theo. Hey, everybody. Happy to be here.
Theo Hicks: Thanks for joining us. Thanks for tuning in, everyone. Today, we’re going to be talking about how to plan for the end. Very ominous, but we’re talking about the exit strategy. A lot of real estate podcasts and content are really focused on the upfront – finding deals, finding GPS from a passive investor perspective, analyzing the deal, understanding the team, and then how to fund the deal, how to get the ongoing evaluations and recaps… But there’s not a lot of focus on the end of the game, what happens at the end of the business plan.
A very common truism in real estate is that you make money on the buy, but in reality, they’re saying is that when you buy it, whatever the price that you buy that is going to impact the amount of money you make at the exit. So really, what we’re talking about is the exit. So what we wanted to do today was go over some of our thoughts based off of a blog post that someone on our team wrote… Our thoughts on how to understand the exit strategy, why it’s important, the different types of an exit strategies, the pros and cons of each… Because if you do make the most money at the exit, that’s probably the most important thing to actually know. And since people don’t talk about it a lot, Travis thought it’d be a good idea to talk about it today. With that said, Travis, do you want to, as usual, introduce in more detail why we’re covering this topic and give some background from your perspective as a passive investor, maybe when you realized that the exit strategy was actually one of the most important aspects of passive investing?
Travis Watts: Absolutely, Theo. I was skimming through joefairless.com the other day, and I just came across this mere coincidence… I just had one of those light bulb, epiphany moments… Being that I’m the director of investor relations, and I talk to investors all the time, I got to thinking of the questions I get asked all the time, and this is certainly not one of them… And I thought, why is that? Everyone’s so concerned with what’s the year one projection, and the cap rate, and the purchase price, and all these things, and analysis paralysis upfront… But what about your ability to sell the asset in general?
I just thought of this just now as you were doing your intro… I remember when I first got started, I was maybe a year into real estate, it was like 2010 or something. I went to this conference and they had an opener, someone that came up before the main act, which was about fix and flips and stuff… And they were trying to sell this tax lien investing software platform or something like that. And I got duped, I bought it. It was a couple grand. It was free information I could have found online. But the funny thing was, I got into this platform they were selling and I started searching for things, and a lot of this stuff was more or less swampland. I’m thinking, “Yeah, it’s cheap. You might be able to acquire this land. It’s very inexpensive. How cool is that? But who wants swampland? Who are you going to sell that to?” So you really could get yourself screwed in something like that, and it was a little bit scary. I did a little bit of a step back, thinking about the bigger picture there and the exit.
When it comes to value add deals – this is why I really want to bring up this topic today. Value add deals, for those that may not be familiar – we talked about this on our last episode, but it’s a strategy where you’re buying a pre-existing asset that’s got some problems of whatever type, you’re going in and fixing those issues, and you’re raising the rents over time. I’m simplifying the strategy, but basically, if I had to put a percentage to it, roughly 50% of your return is coming from cash flow and collected rents as you hold this asset. The other half comes from the equity upside, which is the forced appreciation when you go to sell. So really what we’re talking about is your exit strategy could be 50% of the equation, yet nobody’s talking about this. So I thought we have to bring this up on the show.
I’ll share one more story. I’m in a lot of investor meetup groups and there was this one in particular that I was at… It was kind of this newer syndicator, and he’s up there presenting to the group, and he says, “I tried to chase these 100 unit properties, give or take; anything from 75 units to maybe one and a quarter, somewhere in this sweet spot.” He said “Because I’m above the threshold of a lot of mom and pop operators”, which is true “and I’m below the radar of the institutional buyers.” And I got to thinking, “Then who are you going to sell to?” You’re really limiting your potential and who’s going to buy this asset. Maybe another syndicator, maybe they’re looking for bigger deals, too. So it’s great from the acquisition standpoint, but it might end up biting him later when he goes to sell, and maybe he doesn’t hit the returns, because there’s just not a big buying pool for it. So anyway, it’s certainly something to think about, certainly something to ask a general partner if you’re going to be like me, a limited partner, as to what is your exit game plan? Your strategy? Who have you sold to in the past? You may be able to answer that question yourself, which we’ll get into later. But that’s kind of why we’re covering it. I’ll turn it over to you, Theo, if you’ve got any thoughts so far on that.
Theo Hicks: Yes. I think one important thing to realize as a passive investor, what we’re saying is true – if you’re investing in a deal where value is being forced up, then you’re going your make money via cash flow. That depends on what type of investing you’re doing. Last week or seven episodes before this one, we talked about the four different types of investments. Some of them are more focused on cash flow, and less on the upside. On the other end, it’s development where it’s all upside, no cash flow, and then value-add falls in between there. So if you’re looking at a deal — obviously, when you’re investing you want to make money. So for the value of the property to increase, the value of your investment to increase, so understanding how that calculation is done is important.
There are two metrics that are used to calculate the value of the property. It’s going to be the market cap rate; that’ll be based off of recent sales of similar apartment communities. Then there’s going to be the net operating income. Its net operating income, divided by the market cap rate, equals the value of the property. So those are the two metrics that can be changed in order to increase the value of the property. So when you are investing in a deal, the goal, obviously, is to increase the value, so you want to know which one of those two are they banking on? Are they banking on the cap rates in [unintelligible [00:09:49].01] the lower it gets, the higher the value is… So are they banking on the cap rate going down and they’re just going to keep the net operating income the same or just have it go up with inflation? Do they plan on making the market cap rate the exact same, and increasing the NOI? Or is it going to be a combination of each?
So that’s why on the one hand, the sales comps are going to be important when they’re buying. Ideally, they’re buying below market rates, because when they do that, then that’s just going to be free equity. If the market cap rate is 5% and they’re buying it at 6%, then they have free equity of 1%, based off of the NOI, for free. That’s obviously one thing that’s important. If they buy it at the market rate, that’s fine. But being the highest price, buying a deal at three cap and a five cap market – probably not the best idea; but at or above is better.
And then what’s even more important, which is rarely talked about, is the exit cap rate, because that’s what’s going to determine the value of the property at the exit. So how are they determining the exit cap rate – some call it the reversion cap rate – is very, very important. That’s one of the most important questions you want to know, that’s probably hidden or not thought about. So there are lots of approaches. Some sponsors will just set it equal to what it is today, and some of them will assume that’s going to go lower.
The best approach is to actually assume the market is going to be worse at exit than at buy. So if they buy it and the market cap rate is at 5%, and they plan on selling in five years, the best practice is 0.1% or 100 basis points every year of the hold. So they’ll assume an exit cap rate of 5.5%. That way if the market is the same, then point 5% free equity. If the market gets better and the cap rates go down, then even better. But if the market does worse at sale – maybe a recession happens, something happens that changes a market cap rates in the area – then the return projections are going to be met depending on how far up the cap rate went.
But as Travis said, it is something that is super important and maybe not thought about… Not like hidden knowledge, but it’s something that you wouldn’t really think about; asking about an exit cap rate or reversion cap rate seems like it’s not that big of a deal, but when you’re talking about millions of dollars or hundreds of thousands of dollars in NOI, a 0.1% difference in the cap rate is going to change the value of that property by a lot. So just some of the things to keep in mind. Ultimately, the question here is, are they banking on NOI, cap rate, or both? If they’re banking the cap rate, what evidence do they have to support that this cap rate is going to go where they say it’s going to go, if they’re assuming it’s going to get better?
Travis Watts: Yeah, that’s a great point. All great points. But let’s talk about the hidden knowledge thing that you brought up. I was watching a webinar… I look at a lot of deals, for anyone who’s not aware; I look at a ton of deals. And I was on this crowdfunding platform, because someone asked me a question about it, and I was checking it out… I’m watching this webinar presentation on this deal; it was out in Florida. Everything looks great; projections look great, cash flow looks great, the exit looks great… I’m thinking “Wow, this seems like a pretty solid deal.” Well, the thing they left out was the reversion cap rate. No one talked about it in the presentation, no one asked about it in the Q&A… So I circled back with that sponsor afterwards and I said, “I only have one question, because I didn’t hear it. Maybe I missed it. But what’s your projected exit cap?” They were buying at five cap, basically, and they were projecting a four cap on exit.
Theo Hicks: Oh, no…
Travis Watts: I thought, ” Man, right out, I’m done.” There’s no way. I wouldn’t touch that thing. To your point, if they were buying at a five cap, the answer I was looking for was 5.5, maybe six; some conservative approach, assuming that the market had softened. Then those projected returns I’m looking at would then become a lot more conservative. But instead, they were taking a very aggressive approach, to try to make that deal look good. So this needs to be part of your criteria, anybody listening who’s a limited partner, like I am. I’m such a big advocate for self-awareness, writing down your goals, your criteria on these deals… That has to be one, is to look at cap rates. That’s my little rant on that.
But at the end of the day, Theo, and everybody, all of what we’re talking about, it’s a balancing act of risk. What we’re really talking about is what’s the risk. So you have asset classes, property ties, business plans, leverage, the time horizon… But really, at the end of the day, you’re trying to answer two questions. Is it likely that I’m going to make money? How much money? And am I okay with those projected returns? But more importantly, the feasibility of that. So I’m always trying to stack up when I’m listening to presentations or when I’m on calls with general partners… What I’m trying to figure out is, “Okay, I understand what you’re telling me. I understand that you’re saying it’s going to be this kind of percentage, this kind of return this kind of whatever. But what do I have to go by to give me certainty around that?” That’s why track record and experience are so important. How many times have you done this? Is this your typical business plan and business model? Is this your typical hold period? Typical underwriting structure? All these kinds of things. I like to know about the good, bad, and ugly of past performance. Do you have deals struggling right now? Have you lost money? Have you had capital calls as a company? I could go on and on. All I’m really talking about though is assessing the risk in all of this. So those would be my thoughts on that. I’ll turn it back to you, Theo.
Theo Hicks: Exactly. Assessing the risk and then what you’re comfortable with. As Travis mentioned, there’s a lot of different types of syndications you can invest in, with different types of exit strategies, and there isn’t really one that’s objectively better than the other, always, at all times. It just comes down to what your goals are. Sometimes there are syndicators who will buy a property, and they don’t really have an end date. They’re going to sell at some point, but they don’t really have a set number of years when they’re going to sell the property. It might just be they buy a core asset that’s already fully completed, and they might just hold it for a while. So if your goal is to have a very low-risk investment and make a return, and you’re not necessarily worried about making a large chunk of capital at an exit, then that might be a good strategy for you.
Another long-term hold strategy would be they might do a value-add play, but then rather than selling once they’ve completed the value-add, they might refinance, or do a supplemental loan, and then refinance. That way you might get, maybe not as much money back as you’ve gotten if they would have sold it, but you’ll still get a sizable return, assuming that the GP gives the LPs refinance proceeds. But then they’ll keep holding on to the deal and you’ll keep making cash flow. The cash flow might be the same, it might go down, it might go up, depending on how big the refinance was, and things like that. Other ones might plan to fully reposition and sell after three to five years. When that happens, you get all your money back, plus 50% or so profits. Again, everything depends. These numbers aren’t an exact science.
Then you’ve got a development deal, where there’s no cash flow at all, and then they exit after two or three years, or maybe they refinance and they hold… So there are all these different exit strategies, so you want to kind of ask yourself, what do you want? Do you want to double your money in five years and then get it all back? Do you want to just make a cash flow, and then that’s it? So understanding what the exit is, is going to determine which type of syndication you invest in… Because if you want that equity upside, but you also want to get the equity, you don’t want to sit there and be bigger, then you’re going to want to invest in a deal where they’re going to fix it up, force that value up, and then sell and get you your money back. You’re not going to want to invest in a core turnkey asset that is going to cash flow.
Travis Watts: Exactly. Another one that just came to mind too is a REIT roll-up. Sometimes these syndicators, they’re buying portfolio deals, which means maybe two or three properties, and they’re putting them in one small portfolio, and then they have lots of these portfolios. Then they’re going to find a REIT, maybe a pre-existing, real estate investment trust, or maybe a newly formed REIT, who’s going to acquire all of those properties in one big package. I’m using the term REIT roll-up. Maybe it’s a jargon term in the industry, but basically, you’re wrapping up all of your assets and selling them all off either to Wall Street, or it could be a private REIT. But that’s another exit strategy. But here’s how I look at it… There are really four common exits; I’m not saying this is all-inclusive here, but you could sell, like I just said, to a real estate investment trust, to a REIT, publicly traded or private. That’s one thing. You could sell to institutions, so pension funds, insurance companies, etc. That’s institutional capital, in layman’s terms. Again, not all-inclusive. Syndicator groups, and then individuals, and/or family office, things like that. It just kind of depends.
Let’s talk about that. Institutions and REITs, typically… Again, I have to use a generalization here, and that’s the disclaimer… But typically, they’re investing for cash flow and for yield, and newer properties, or recently renovated properties. I would say they’re mostly in the A class and the B to B plus categories of assets. They’re not in the business, usually, of value-add and doing lots of heavy turnaround and repositioning. They don’t want to buy assets that have leaking roofs and HVACs going out and under-market rents. They just want a turnkey asset; they want to place their capital, and they want to have virtually no worries for 5, 10, 15 years, whatever their business plan is. Now when you’re talking about syndicators and individual buyers – again, as a generalization – they’re typically looking in the B and the C class space for what these institutions are basically offloading… Because now they have problems, they need work, the rents are unable to be pushed anymore, because it’s an older asset that hasn’t really been kept up. Maybe it’s got outdated amenities… All these kinds of things. So typically, they’re looking to go in with a value-add play, and renovate, and bring things back up to the market level, and then sell back oftentimes to REITs and institutional capital and things like that. It’s just different business plans.
To your point, Theo. There isn’t a right and a wrongm and a lot of people, they prefer core assets where they’re looking for just that natural inflation, if you will, to kind of lift the values over time. They’re not looking for that forced appreciation in the deal. So those are the four exits, in my opinion, that are most common. Those are my thoughts on that. If you have any final thoughts, Theo?
Theo Hicks: Yeah. I think we went over a lot of information here. [unintelligible [00:20:46].05] condense it down… So just as a passive investor, what questions do you want to have answered based off of the exit strategy? So the first question, arguably the most important question about the exit strategy is, what is that exit cap rate assumption? What is that reversion cap rate assumption that will determine how conservative or aggressive they are being? And again, the best practice is to have an exit cap rate that is higher than the current cap rate. How higher that is, it depends, but it shouldn’t be lower than. Travis gave the story of the 4% exit cap rate, 5% in-place cap rate – probably not the best idea.
Then the other question based off what Travis just talked about is who do you typically sell to on the back end? Or who do you expect to buy this property on the back end? And then based off of what Travis said, was their answer aligned to what Travis just talked about? So are they planning on buying a B or C asset and doing a value-add play, fully renovating it and then eventually selling it? Then they should say that they plan on selling it to an institution, or if it’s like a fund, a REIT. But if they are going to buy a B property and just kind of hold it and not do anything, and then claim they’re going to sell it to an institution – well, that’s probably not going to happen.
I think those are the two most important questions – what’s the exit cap rate, and their justification for how they came up with that? And then two, who’s your typical buyer? Who do you expect to sell to on the back end?
Travis Watts: Yep. Those are great points. That’s a great way to phrase it, too – who is your typical or ideal buyer in this situation? What type of individual, or institution, or what have you. Because the answer, quite frankly, is that nobody knows. Five years down the road who’s going to buy this deal? I don’t know. Nobody knows. But the point is, you’re looking for competence. You’re looking for “Well, we’ve thought this through”, let’s put it that way. “In the past, we’ve sold to three institutional buyers and one syndicator.” Well, that kind of answers your question there. To your point, Theo, you just want to make sure all this stuff aligns with what you’re wanting. Does that help you accomplish your goals? Are they being realistic with their business plan and approach? That’s it.
Theo Hicks: The competence thing is huge [unintelligible [00:22:55].14] trap them or trick them… But these are important things to think about, and you can kind of gauge the sophistication of the GP by asking them some of these questions that they probably aren’t asked a lot. If they don’t really have an answer… They can say, “I don’t know, I can figure that out for you, and get back to you.” But if they start making things up or sound like they don’t know what they’re talking about, that could save you. Something as simple as that could save you from potentially losing your capital.
Travis, going back to your example, which was perfect – if you didn’t know to ask that question because it wasn’t presented to you, you would have invested in a deal with the return projections based off of a very aggressive cap rate assumption. You’re just asking that question, and they’re getting their honest answer, which we’re assuming the markets going to get way better when they sell, or them saying, “Well, I never thought about that,” or whatever. It just kind of gives you an idea of who you’re working with here. So is there anything else you want to mention, Travis, before we wrap up?
Travis Watts: No, I think we hit it. So for anybody listening, feel free to reach out to us with any additional questions or leave a comment. We’re happy to answer those.
Theo Hicks: Yes, any questions? Just email me at theo@joefairless.com. We’re also doing a new shorter segment called 60 Second Question. So you submit your Actively Passive Investing questions. You can email those to me at theo@joefairless.com. If you’re listening to this on YouTube, you can also leave it in the comments section. Completely up to you. Just leave your name and your question, and we will read the question and we will answer it in 60 seconds or less. 60 Second Question, email theo@joefairless.com, and we post those on our YouTube channel. So as always, Travis, thank you for joining me today. Best Ever listeners, as always, thank you for listening. Have a Best Ever day and we’ll talk to you tomorrow.
Travis Watts: Thanks, Theo. Thanks, everybody.
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