As I’ve been meeting and sourcing deals from more and more sponsors, I am noticing a trend amongst operators who do not raise institutional capital. Many are unwilling to share their underwriting analysis or at least are quite hesitant to do so. Being a numbers guy, this has come as a big surprise to me as I believe the two most important components of any deal are the numbers and assumptions (the underwriting) and the managers of the investment.
The sophisticated equity providers we work with such as family offices and private equity funds not only want to see our underwriting, but they want to have conference calls discussing every last assumption and line item on the pro forma. We are happy to do this and appreciate all of the tough questions we field because they force us to challenge and question not only our assumptions, but our proposed business plans as well. This sharpening of the saw enables us to continually improve our future underwritings and acquisition methodologies.
While it is true that at the end of the day, you are investing in people not deals, no operator is good enough to overcome bad numbers. Conversely, no deal can underwrite so well that it can overcome incompetence on the manager’s part. With this being said, it is almost astonishing that sponsors are able to eschew sharing their underwriting with potential investors and still have investors subscribe to their deals. I wonder if this is indicative of the credulity exhibited by some investors late cycle or if this is a secular phenomenon occurring amongst unsophisticated retail investors. From the sponsor’s perspective, I simply don’t see the upside in not sharing the numbers and assumptions driving the investment you are selling your clients. The only valid hurdle I can think of is that a sponsor may have proprietary methods or algorithms driving their model which they wouldn’t want competitors to see. But come on! It’s just an excel spreadsheet. Furthermore, I think an operator’s underwriting tells much more about them than just their deal.
Transparency is a huge component of the investment business and I believe the unwillingness of a sponsor to share their underwriting could be indicative of a fundamental lack of transparency that could potentially manifest itself in other ways during the investment lifecycle. Evaluating the model itself can help shed light on the sophistication of the shop, and the level of rigor they apply to their analysis. Next, reviewing the assumptions in the model can potentially provide insight into the natural disposition of the manager; are they naturally conservative or aggressive? Lastly, it is much easier to evaluate an investment by reviewing the underwriting rather than relying on the spoon-fed information the sponsor is proffering. I’ve seen sponsors manipulate the numbers in myriad ways. I’ll provide a few examples (hopefully you’ll find them as entertaining as I do while reinforcing the idea that proper due diligence is paramount): some sponsors will advertise “attractive” DSCR on a year 1 pro forma basis using the interest-only payment of the loan (DSCR, at least the way the banks underwrite, is always referring to amortized debt payments which are invariably much larger). This is scary because an attractive DSCR of 1.5 based on an interest only basis is actually a DSCR of roughly 1.15. And for those of you familiar with bank underwriting standards, they typically insist on a minimum DSCR of 1.25. So, what is put forth as an “attractive” deal wouldn’t make it through the bank’s underwriting. I’ve also seen sponsors purchase a property with a trailing vacancy of 14% and project a year 1 vacancy of 5% (unless there is a good story for why there is this level of readily-curable vacancy, this is too aggressive for me).
Unsophisticated investors often rely heavily on the cap rate because this is all they understand about underwriting. Thus, some sponsors claim to be purchasing a certain cap rate but in reality, their number is heavily manipulated by pro forma numbers or not adjusting for taxes. Tax adjustment alone can account for a 50 basis point compression or more in some situations. Regarding capital reserves, we choose to include them “above the line”, meaning they are factored into NOI and cap rate. However, many operators choose to put replacement reserves “below the line” in order to show a higher cap rate to their investors.
The reasons above and these few examples compel me to believe that my family as well as my father and I’s capital raising business would steer clear of any operators which are unwilling to share their underwriting model. If they are raising capital for a blind-pool fund, this is of course impossible as there is no deal specific model. However, if the fund is already in progress, good due diligence would be to review their internal underwriting for a given acquisition and compare it to the actual numbers available thus far.
Here’s a final thought: I’ve been considering launching an additional advisory business which performs underwriting and due diligence on behalf of smaller, retail LPs contemplating these sponsored multifamily investments. I believe this service could be especially beneficial for investors considering investing with groups which are not forthcoming with their underwriting. Please let me know your thoughts on this business model and if you or someone you know might be interested.