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Valuation & Investing Near the Top
January 19, 2020
A discounted cash flow is the most revered form of valuation due to the fact it is an intrinsic valuation. However, the most predominant model used for valuation and underwriting is the forward relative valuation model. Even most DCFs are really just relative valuations by virtue of using some form of multiple (cap rate, EBITDA multiple, PE, etc.) to derive a terminal value, which is an important input of a DCF. The reason employing a multiple clouds an intrinsic valuation is because multiples are determined and swayed by economic cycles and investor psychology. This means that while taking the purchase cap rate or market cap rate and adding 10 to 20 basis points per year to your terminal cap rate is conservative, it still relies on current market conditions to derive its valuation.
However, I’m comfortable using a reversion cap rate, which is a multiple, for terminal valuation and recognize that this makes our underwriting methodology a forward relative valuation, not a DCF. This is because we don’t rely solely on IRR (the discount rate that makes the net present value of the future cash flows to equal zero) to make investment decisions. Instead, using the first the years’ cash on cash return is a more valuable benchmark to pay attention to since those returns are less speculative. Unlevered returns are also helpful to look at but long term, fixed rate debt locks in the levered return hopefully long enough to exit at a time when rates are normalized if a shift occurs in the interim.
Multifamily properties have experienced a rapid increase in value due to the ability to finance acquisitions with historically low interest rates over the past decade. What will happen when rates normalize or even move higher? Buyers will have to factor prevailing interest rates and access to leverage into the future pricing of assets. This means that as rates rise, investors of multifamily (and other levered investments) will see a decrease in valuation. Additionally, a compounding effect occurs. As rates rise, all investments along the “capital market line” see an increase in prospective return. All investments’ prospective returns are built off of the risk-free rate (this spread is known as a risk premium). So, while rates are increasing (which decreases the value of multifamily investments due to less favorable financing) the prospective return for all investments increases, forcing investors to require a higher return on investment than before on the same investment. For example, when the US 10-year treasury is at 2%, investors will happily buy core real estate assets in primary markets at 4% yields. However, if the US 10T were to rise to 6%, investors would not bid those same assets to a 4% cap. This is one of the many reasons why focusing only on IRR, especially when using relative valuation techniques (which we all do), can get you into trouble.
The beauty of intrinsic valuation and buying at a discount is having the comfort that your investment is strong regardless of short-term market swings brought on by the credit cycle and investor sentiment. This requires careful analysis of the aforementioned risk premium, meaning you need to find deals with a favorable risk-adjusted return. Another way to mitigate risk when buying while credit is cheap and plentiful is to opt for fixed rate debt for 7 to 12-year terms. Since the credit cycle is typically 5 to 7 years, 12-year paper would most likely be sufficient to catch the top of the next cycle and exit when valuations are back to cyclical highs. Throughout history, investors got themselves into the most trouble when overleveraging long term assets using short term debt. It is fairly simple to avoid this pitfall but sometimes difficult to ignore the siren song of high returns using leverage. However, credit throughout this current economic cycle has been relatively constrained compared to before the 2008 financial crisis, which is helping abet our current 111-month expansion. So, while interest rates are still very low historically, credit quality is stronger than past cyclical highs due to lenders being more conservative in their underwriting. In short, long term financing can be a great way to avoid terminal/balloon risk, or being forced to sell/refinance at the wrong time. Another way to mitigate the risk of leverage is by having a fixed interest rate which eliminates interest rate risk.
The counter argument to fixing debt payments is that historically, floating rate debt performs better than fixed rate debt in almost all economic scenarios. Historically, the market has overestimated the path of LIBOR thus lenders or dealers have typically ended up overcharging for interest rate swaps and caps. A bank’s spread is also partially based on the projection of rates into the future, meaning they will demand a higher spread and overall interest rate for fixed rate debt. However, history has shown that the market underestimates the path of LIBOR during the tightening portion of the credit cycle. I am an active follower of Pensford Financial Group which has already put together a great analysis of fixed versus floating debt so I won’t bother you with my own thoughts here. Pensford also releases a LIBOR forward curve which I use to model floating rate debt for my five-year cash flow analysis. Holding floating rate debt is always riskier than fixing debt payments but some thought and consideration should be put into the possibility that an alternative such as interest rate caps could perform better on a risk-adjusted basis. At this point in time, fixed over floating rate debt is a no brainer as we are in the throes of a tightening cycle and banks have come way down in their spreads due to increased lending competition.
In summary, the solution to investing near cyclical highs is focusing on less cyclical assets such as multifamily, evaluate opportunities based on cash flow, not revenue growth or market appreciation, avoiding short-term business plans and short-term debt, and fixing debt payments. Oh, and buying fundamentally strong assets in fundamentally strong markets at a discount also helps but is extremely difficult due to the excess liquidity available at the end of the business cycle. Also, buying something that is less overpriced than the comparables doesn’t mean that the subject asset isn’t overpriced, just less so.