Earlier this week we had a new experience, as we were on a Zoom call with a potential investor – that he was taking from his Private Jet. The wonders of technology made it happen, and it mostly worked. I walked away from that call in awe of the connectivity the world has, shaking my head at the fact we had a video conference with a guy on a plane.
I also walked away from that experience feeling pretty good about ourselves—and specifically our underwriting. As we were walking through some assumptions in our model, he stopped to congratulate us on being conservative. His team highlighted a couple of specific numbers that we had programmed in that normally they didn’t see operators do—when they are looking for ways to boost the projected investor returns. Specifically, we set our expenses to be higher in Year 1 than the current operator; and we show our Capital Reserves above the line (which “hurts” your NOI). He thanked us for doing both of those, for saving them the time of having to reprogram those numbers, and for being conservative. And you can imagine how many deals they likely see and review.
We thanked him for the compliment—and mostly for being thorough in the review of the deal. Whether we end up working together or not, it was a great reminder to me about how important it is that Wildhorn remains steadfast in our conservative underwriting. It’s something that we talk about a lot. And something that we truly believe in. We didn’t change our presentation or assumptions just for that meeting—we wouldn’t do that for any investor. It’s just how we’re wired.
A core principle for Wildhorn Capital is to ensure we are good stewards of Investors’ capital. From the first outside dollar we took, I’ve never shirked from that responsibility. And I think the best way to do that is to be (and remain) conservative in our underwriting. We aim to under promise and over deliver. And present deals we have true conviction about–where we are confident we’ll meet and beat expectations. To date, that has worked. We’ve exited 6 deals, returned over $100,000,000 to investors and crushed our initial proformas. I think much of that is due to the fact we were truly conservative in our underwriting.
In this business, being conservative isn’t anything new. Or at least saying your conservative isn’t. Everyone says they are conservative in their underwriting — and can point to a few items where they will show you how they are being conservative. But what we’ve noticed over the last few years is that many Investor decks we receive and review aren’t really that conservative at all. We aren’t judging anyone else’s business or decisions—and we don’t really blame them.
Underwriting is just a tool to show a proforma—a projection of what you believe a (or the) likely outcome of a project is. It’s also the tool that generates your marketed investor returns—the IRR, Cash on Cash, Equity Multiple, etc—the metrics on which investors gauge and weigh investment decisions. So anyone looking to raise money—in any industry—needs to generate something that they believe provides a good Return on Investment for the risk the potential investor is taking.
Over the last 5 years, as the Real Estate market (and multifamily specifically) have gotten uber competitive, it has brought the (likely) investor returns down as well. What was previously a ~20% IRR became an ~18%, then 15%, then 13%, etc. The lower that number goes, the more concerns anyone raising money has about their ability to attract capital. At some point the returns just become uninteresting to investors—despite all the inherent tax advantages and inflation hedges it provides.
In an effort to continue promoting “mid- and upper-teens” IRR’s, operators have to start changing decisions and getting more aggressive in their underwriting. The more aggressive you get, the more risk you are adding to the project. And in a world where we’re in essence competing for attention and investor capital, it can be tough to hold firm in your conservative beliefs.
Which brings me back to our video call from the private jet. And why we walked away feeling very good about the compliment we received.
Since our inception there have been three non-negotiable principals to our underwriting. Rules that we simply won’t violate—no matter their impact to our proforma and despite our temptation to “compete” and show higher returns. It can sometimes be frustrating to not feel like we’re getting credit for adhering to these rules, knowing that violating just one of them would significantly impact our marketed returns. But, keeping these intact is what helps me sleep at night—knowing we’re being conservative and good stewards of investor capital.
The three key principals you ask?
- Max 70% Leverage. We simply won’t go above 70% Loan to Cost on a deal. We have routinely turned down proceeds from lenders who would have been happy to give us more dollars. We’ve seen a lot of investment decks where folks are taking 75% and 80% leverage out and/or adding in a preferred equity or mezzanine loan on top of the equity as a method for boosting investor returns. We’ve even had a few investors ask us to take more proceeds and question why we wouldn’t—knowing it would boost their returns. However, we believe that the fastest way to add true risk to your real estate investment is to get over leveraged. If values slip even the slightest amount, you can get upside down and all of a sudden you’ve got bigger problems than simply not meeting your marketed returns. No thank you.
- Cap Rate Expansion. Perhaps the fastest and easiest way to boost investor returns is toggling your assumption around the Cap Rate at exit. This is especially true as Cap Rates have compressed over the last few years, as each dollar of NOI you’ve created has become that much more valuable. Again, we see a lot of decks where the Cap Rate is flat from purchase to exit; sometimes we’ve even seen compression where the exit rate is lower than when you bought it. This is probably the biggest red flag when we see it, as no one is accounting for any sort of pull back to the economy/industry—such as the one we’re experiencing right now. In our models, we always have a yearly expansion in the cap rate—and we’re typically trying to land in a spot where the exit Cap Rate is at least 100 bps higher than where we might be buying it.
- No Refinance. No Early Exits. Because IRR is a time-driven metric, the sooner you can return capital to investors, the higher the projected IRR becomes. To boost returns then, many models incorporate a refinance into their projections where 18-24 months in they plan to get a new loan and return a big chunk of capital to investors. Or, they will simply bake in the exit at month 24 or 36. We underwrite all our deals on either a 5- or a 7- year business plan. And we never program in a refinance or supplemental loan. Yes, marketing a shorter business plan or executing a refi early on would boost returns. It also paints us into a corner and limits our options. We always underwrite the full term of whatever loan we are initially getting—riding that out until sale. Will we explore a refinance or supplemental loan? Or even a sale at month 24 if that makes the most sense? Of course—and that may even be the plan going in. But we’re going to underwrite and show the “worst case scenario” rather than trying to time the market perfectly to show a higher marketed return.
Over the last few years, remaining committed to these principles has been tough. The marketer in me wants to highlight flashy and sexy numbers. But every time we have that discussion, we always come back to making sure we protect investor capital first and foremost. To ensuring we can under promise and over deliver. Now that we’re seeing the economy start to slow, interest rates rise and some uncertainty for the first time in a long time, we’re feeling very good about our decision to have stayed disciplined and protect the downside as much as we’re trying to maximize the upside.
Getting positive feedback from 30,000 feet in the air doesn’t hurt either.