Resources

by: Christian O’Neal

A simple but powerful exercise to illustrate the importance of growth and why CRE transactions are so low right now.

Buyers solve for their weighted average cost of capital / IRR to determine the price they are willing to pay for an asset. What is often less stressed is something called weighted average cashflow obligations. WACO calculates how much yield (NOI) is needed to pay senior debt service and a certain annual cashflow coupon to equity investors. In low / questionable rent growth periods, in place cashflow becomes increasingly more important because in reality, we pay a multiple on income streams. Growth is not guaranteed.

In many cases today, buyer’s weighted average cashflow obligations are too high to be covered by in place cashflow. So, one of two things need to occur to close that bid / ask gap. We either need NOI growth (rent growth, in most cases) or lower weighted average cashflow obligations (these days, debt would have to move, not equity requirements). In an environment where you can lock in 5% + yields with no risk for 12-18 months, cashflow requirements for risky assets become stickier. Investors are less willing to accept stabilized cashflow below risk free rates of return, especially for sub-core assets, which makes all the logical sense in the world.

In this example below, we have a 200-unit apartment complex renovated 4 years ago, assuming mid 80s vintage in a secondary market, with an asking price of $24M or $120k/unit. The seller wants to sell for a 5.9% cap off of T-1 revenue, adjusted for reassessed taxes. There is a little bit of meat on the bone through optimizing expenses and increasing rents ever so slightly, so we can call this a light value-add. Based on true comps and realistic assumptions for other units nearby, we can assume to spend a light $3,000 / unit to achieve a 7% NOI boost on a stabilized basis over 2 years.

Does the deal work at the seller’s ask? Well, it depends on buyer’s willingness to stake their returns in future rental growth. It is hard to do that today.

On an interest only basis, a buyer would be able to meet their weighted cashflow obligations and pay a 6% coupon to investors upon stabilization.

On an amortizing basis, assuming a fairly reasonable agency execution at a 1.65% spread over the 5-year T, the buyer does not meet their weighted cashflow obligations. To meet obligations, a buyer would need to pay 11.6% less than ask for the property or grow NOI by 11.05%, on top of the 7% business plan lift.

While some investors may bite on future rental growth and the ability to meet weighted obligations during interest only periods of their hold, the buyer would still need to pay an inflated price. At the asking price of $24M, the buyer’s untrended ROC is a 6.01%, and if the market is a 6% cap, they did not create any value. In which case they’d rely on future growth or lower treasuries (highly speculative based on expected sustained inflation) to bail themselves out of the deal.