4 Trends in Apartment Syndications for Optometrists
At New Sight Capital, we think it’s one of our responsibilities to not only educate other optometrists about apartment syndications, but to also keep them informed of trends within the landscape. The basics of syndications don’t change much, but trends in this space can influence investor returns. We’ll touch on 4 trends that we think are important for investors.
Cap Rates are Still Compressed and Uncorrelated to Interest Rates
Many ODs have heard the term “multiple.”. For those who have sold their practice to private equity, it’s understood that practice valuations are equal to a multiple of the practice’s EBITDA. Cap rates also express a valuation multiple but in a different format. Technically, “capitalization rate” is equal to the Net Operating Income (NOI) divided by the sale price. In essence, a “5 cap” equates to a 20 multiple. The lower the cap rate, the higher the value of the property. Over the last several years, there has been considerable compression of cap rates, resulting in significant appreciation of apartment valuations. And, while cap rates can be influenced by interest rates, they are not as correlated as many people think.
That’s because there are two other factors that have greater influence on cap rates: NOI and risk outlook. Well operated apartments continue to see stable growth in NOI. There also continues to be a flight towards the inflationary-resistant and stable large multifamily asset class. Retail investors, pension funds, life insurance funds, and institutional investors continue to see lower risk in apartments. These trends will most likely continue to keep cap rates compressed and show that cap rates and interest rates are not correlated. Ryan Soverino, chief economist at JLL, says that “40 years of empirical evidence supports this view….The poor correlation (between cap and interest rate) exists at both the short end of the curve with the fed funds rate and at the long end of the curve with longer dated Treasury yields.”
Interest Rates May Affect Distributions but Not Valuations as Much
How are rising interest rates going to affect offerings that take place in a few months from now? The good thing is that any syndicator is locking in rates ahead of the offering, and those rates are incorporated into the underwriting model that gives investor return projections. Hence, the higher rates are taken into account. What’s the result? The most tangible impact on offerings yet to occur will be attenuated returns. How much this impacts returns on future offerings is anyone’s guess. Yet, it’s most likely to affect the cash flow side more than the valuation side. Remember, apartments are valued like businesses. Think of NOI as akin to EBITDA (Earnings Before Interest Tax Depreciation Amortization). NOI doesn’t include debt/interest because those liabilities vary from buyer to buyer. But, cash flow to investors certainly is affected by debt/interest expenses. Instead of syndication investors being introduced to offerings that have 12+% average cash-on-cash returns, they may start to see more 6-10% average yearly cash-on-cash distributions. Total returns may stay the same over the lifetime of the syndication, but distributions may trend downward on future offerings.
Lower Leverage Can Have Modest Impact on Returns
One change we’ve seen in the last few months, as the lending environment evolves, is lenders giving less leverage to syndicators. In late 2021, syndications were often securing debt amounts equal to 80% of the cost of the asset with some/all of the rehab costs included. We’re now seeing lending terms in the 75% loan-to-cost range, with less appetite to finance the majority of rehab costs. That means syndications will need to raise more capital from investors. Investor capital is really equity. The more equity that is being raised, the more diluted each share becomes. Dilution of equity results in dilution of returns. Let’s take a look at an example. Let’s say we have a $45 million value-add apartment with a $3.5 million capex budget. At 80% loan to cost leverage, projected cash-on-cash returns are in the 13.5% and total returns near 110% on a 6 year hold. Changing just the loan to 75% loan to cost leverage reduces projected cash-on-cash to 12% and total returns to 99%. Syndicators will focus on counterbalancing this impact, but the reduction in leverage will affect projected returns on future offerings.
Lender Stipulations on Distributions
While lender restriction on the payment of investor distributions in syndications is not a new development, we are seeing a trend towards more lenders negotiating for more stipulations. Mostly, the restrictions center around the completion of “capex” prior to paying investor distributions. Capex refers to capital expenditures and includes rehabs on the property (structural repairs, exterior and interior renovations). As many apartment syndications are “value-add” models that require renovations in order to increase rents and valuations, capex can be significant. It’s not uncommon for value-add syndications to have a capex budget of $2 to 4 million.
We have seen some lenders require that 100% of capex be completed before investors can be paid distributions. In theory, the syndication could be ahead of projections and abundantly cashflow positive but still unable to pay distributions until it meets the lender requirements for capex completion. The good thing is that a 100% capex completion hurdle is rare, but lenders are still negotiating some proportion of completion requirements into their loan terms.
Obviously, this will affect cash-on-cash returns (cash distributions to investors). Specifically, this will show up in two ways. First, you’ll see a longer projected horizon for the start of investor distributions. Whereas it was most common to see offerings project distributions to start 6 months after closing, this is already evolving into a 9 to 12 month projection. Note, however, the amount owed to investors still accrues from closing—it just will be longer until it’s paid. Secondly, average yearly cash-on-cash returns may be slightly reduced. This may only be a slight influence. In the first year or two, the cash-on-cash will be reduced because of this capex hurdle, but later year cash-on-cash returns will be higher. Since cash-on-cash return for a syndication is really an average yearly metric, the effect may not be severely pronounced.
Of course, we are always here to answer questions about these trends or any other questions you may have. It’s our goal to educate potential investors so they can make decisions that best suit their investing objectives and comfort levels. If you’ve not registered with us yet, please click here to register and receive more information about syndications, as well as updates on current and future offerings. You can also schedule a call with our Investor Relations Director, Caleb Bryan, by clicking here.
