While many recent news articles focus on disruptions in the debt market, it is important to note that the credit crunch has also impacted the equity market. This article summarizes current trends in the equity market; more specifically, the market for institutional joint venture equity in value-added multifamily transactions. Please note that this commentary is a broad generalization; actual treatments by equity sources vary widely.
In summary, equity standards are significantly more conservative today than they were six months ago. Marginal tightening across all underwriting metrics makes for a challenging environment. Conservatism is articulated by higher yield requirements, less aggressive pro forma assumptions and increased risk awareness. Transactions must be compelling, with strong locations, economics and sponsorship. Those seeking investors should test their models for sensitivity and stand ready to defend assumptions. Specific trends and changes in the key underwriting metrics are outlined below.
· Contribution Splits: 90% to 95% co-investment was common in early 2007. Today, 95% is rare. While 90% is still widely available, some investors now cap their contribution at 85%.
· Preferred Returns: Preferred rates range from 9% to 13%. While 8% was once typical, now 10% is more common. Transactions with special risks (entitlement, major construction, etc) may require 12%.
· Yield: Institutional multifamily investors today are looking for 18-20% overall annual yield, using the investor’s conservative assumptions.
· Profit Splits: The investor’s demands with respect to profit sharing vary widely. Straight 50/50 splits were commonplace as recently as six months ago. Today, most use a “waterfall” to subordinate sponsor equity, such as splitting 75/25 until the investor achieves a 15% return, then 50/50 thereafter.
· Purchase Capitalization Rate: Sub-5% cap rates invite scrutiny. Regardless of value-add opportunities, investors are wary of over-paying.
· Exit Capitalization Rate: Cap Rates depend heavily on location, but 7.0%-7.5% is a common benchmark. Investors look for a positive margin of approximately 1.5% between purchase and exit cap rates. 6.0%-6.5% is acceptable in prime metropolitan markets with barriers to entry, like LA, SFO or DC.
· Market Rent Assumptions: In-place and pro forma asking rental rates are aggressively tested against comparable units. Be prepared to defend a detailed comparable analysis.
· Market Rent Growth Assumptions: Investors will consider accelerated market rent growth in strong markets, but primarily focus on returns assuming 3% annual rent growth.
· Sponsorship: Attractive sponsors demonstrate prior experience with respect to market, product type, transaction size and business plan. Sponsorship is critical.
· Debt: If investors are left to establish their own assumptions on debt financing, they are usually overly conservative. Sponsors should provide qualified debt terms to avoid unnecessary penalties. Debt must be secured before investors will commit equity.
· Sensitivities: All assumptions are tested. Investors favor robust investments that can weather a storm. A transaction that works on the margins but not when assumptions are tested will generally be passed over.
· On/Off Market: Broadly marketed acquisitions are heavily scrutinized. Many believe that cap rates are increasing, and assume that aggressive bidders must over-pay by default.
