Passive income is an exciting concept. But don’t be blinded by the shiny numbers you see on an offering memorandum or marketing material and overlook the risk you are taking with your hard earned money. Anyone who’s invested as a limited partner is familiar with the BIG THREE – equity multiple, cash-on-cash return, and internal rate of return (IRR). These are the numbers that get you excited about the deal. You may see a preferred return of 8% in an offering and numbers like “8.8% Average Cash-on-Cash”, 2.2x Equity Multiple, 16.8% Investor IRR.” If its in a market that’s desirable, many stop the underwriting process right there and are ready to sign and wire funds.
Wait a minute. While these numbers are sexy on the surface, they don’t adequately measure the risk. Secondary performance indicators tell the real story. Many sponsors don’t publicize, or even calculate, these lesser known metrics. It’s up to the savvy passive investor to be knowledgable and marry up the deal to their own personal risk tolerance. The first step in mitigating risk in portfolio construction is understanding what the risks are in the first place.
Let’s take a look at some of these performance indicators so you can be a more informed investor and deal analyzer.
Expense Ratio – This is the percentage of effective gross income that is used to pay the operating expenses of the property.
As an active and passive investor, I see a fair bit of deal flow. This is the first thing I look at. Is stated net operating income realistic based on the expense ratio? This is an indicator as to whether to dive deeper into underwriting or not. Dealing mostly in value-add properties, which tend to be older and have more maintenance, if I see an expense ratio below 45%, I don’t trust the numbers. It could be subtle mis-representations or more obvious withholdings, like not accounting for taxes, insurance, or property management.
Expense ratios can be as low as 35% for stabilized properties or brand new properties, and higher than 60% for mis-managed properties. If you see a T-12 with an expense ratio of 60%, its likely an opportunity, but could carry more execution risk.
Expense Ratio = Operating Expenses / Effective Gross Income
Break-Even Occupancy – The break-even occupancy formula tells the investor the percentage of units that must be leased in order to cover all expenses and debt. If a break even occupancy is 85%, that means IF the property has 15% physical vacancy, after expenses and debt service it would break-even ONLY. The preferred return you were counting on would potentially not be paid at this point and your investment would be in jeopardy.
This is as specially important in destabilized, value-add deals. If the sponsor is underwriting a 5% vacancy rate and the break-even occupancy isn’t much lower, its cause for pause. It’s also worth studying the average vacancy rate of the market to understand if projections are realistic.
Break-Even Occupancy = Operating Expenses + Debt Service / Gross Potential Rent
Default-Ratio – The default ratio takes the break-even occupancy a bit further by accounting for economic vacancy, which is why I give it more weight. A property may have 98% physical occupancy, but economic vacancy accounts for factors like non-current tenants (bad debt) and concessions, not just un-occupied units, and is used to calculate effective gross income (versus gross potential rent).
The default ratio is useful in determining how far income would have to fall from current levels in comparison to effective gross income.
In the previously used example, if the physical vacancy were 15% with a break-even occupancy of 85%, all it would take is one non-paying tenant to throw the property into risk of default. Most larger properties, regardless of class, have bad debt, so I like to account for what’s on the T-12, and some, to ensure I’m accounting for any unexpected economic events that could put hardship on tenants’ ability to pay. As we saw in 2020, sometimes black swan events can occur that are out of anyone’s control. Being conservative and underwriting a buffer is prudent.
Default Ratio = Operating Expenses + Debt Service / Effective Gross Income
Yield on Cost (YOC) – This is my favorite metric to measure in forecasting a value-add project’s potential return. When calculating an in-place cap rate on a value-add project, you’d divide the current net operating income by effective gross income. But what if you have a $200,000 renovation budget that will result in higher rents? That’s cap ex budget is not accounted for in the purchase price of the property.
Let’s say a value-add project has an NOI of $60,000 and a purchase price of $1,000,000, a 6% in-place cap rate at acquisition. The operator injects $200,000 to update the property, bringing the total project cost to $1,200,000. The improvements allow for higher rents and lower expenses, bringing the NOI up to $100,000. This results in a yield-on-cost of 8.34% ($100k/$1.2M).
The yield on cost metric helps measure the difference between the market cap rate and what the total project will yield to investors. In the example above, if the market cap rate were 7%, with a yield on cost of 8.34% (the development spread), you can be confident that the renovations are leading to actual value to investors. The higher the spread, the better.
Yield on Cost = Pro Forma NOI / Total Cost
Debt Service Coverage Ratio – the DSCR is used by lenders mostly. Lenders are definitely underwriting risk and this is one of their favorite formulas to qualify it, so passive investors should take notice. DSCR, represented as a decimal, is the ratio of cash flow to debt service. The higher the number, the safer the deal. Most lenders require a minimum debt service coverage ratio around 1.25. You may see lower, but that means the lender or the borrower or both are taking on additional risk. You may also inquire about what expenses are included in the ratio. Some lenders will underwrite to include taxes and insurance, but leave out other less quantifiable costs. If the DSCR isn’t factoring in total expenses, it may be misrepresented on the high side.
Debt Service Coverage Ratio (DSCR) = Debt Service / Effective Gross Income
IRR Partitioning – This is simply a percentage of the IRR that is generated through cash flow from operations versus appreciation at the time the property is sold. As a cash flow investor, I’m a bit more risk averse. I want to buy directly, or invest passively, in deals that cash flow from day-one, that have upside to deliver higher COC through a value-add strategy. I’m, therefore, not as concerned with a projection that a property will sell for 30% higher five years from now. Although I certainly will enjoy the 30% boost, its a bit more uncertain than the monthly cash flow.
I’d like at least 60-70% of the IRR to come from cash flow. Alternatively, someone with a higher risk tolerance wanting more upside, may be okay investing in a development project with no scheduled cash flow for three years. If this deal were to sell in year four, the total IRR may be 90% derived from the spread the developer made on his/her cost versus sale price. Could be a home run, but leaning towards cash flow is playing for singles and doubles. Small ball wins baseball games.
Clearly, when the percentage skews to one side or the other, risk subsequently rises or goes down. This makes IRR partitioning a nice metric to measure, as specially if where the bulk of projected returns are coming from isn’t obvious.
Summary
There is risk in every investment. Quantifying it is the important take-away from this piece, so you can construct a well diversified portfolio. Don’t be blind to the risks you are taking by not digging into deals beyond the offering memorandum and the shiny, publicized numbers. The metrics discussed will give you the underwriting tools you need to become a better active or passive investor.