Episode 74 - Building Classification
In commercial real estate, a property’s “building classification” is meant to be a short description to provide an investor with information about the building (age, location, amenities, condition, rental rates, sales price, etc.).
In Episode 74 of Investing with GoodLife, Rohan and David discuss building classifications, explain the difference between Class A, B, and C buildings, and discuss how building classifications are used in the real estate industry.
What are the Building Classification Classes?
In commercial real estate, all buildings are classified into three classes: A, B, or C buildings. Since every type of building is classified, investors in the real estate industry are always discussing building classifications.
To start at the top, (A) buildings are your top-of-the-line buildings. (A) buildings are often the newest in age and tend to have luxury finishes, such as granite, high end cabinets, and stainless steel appliances. They usually generate the highest rents in the market and also have the highest sales prices. For the building location, they are usually located in what people refer to as class (A) locations. For example, in New York, a class (A) office building could be located in Downtown Manhattan or on Wall Street. It could also be a brand new building. Today these buildings usually include special upgrades, for example, due to COVID, most class (A) buildings now have new HVAC systems, air filters, and touchless elevators.
The next building class is (B) buildings. (B) buildings are not as fancy as class (A) buildings. Class (B) buildings are usually older buildings but they’re still of good quality. In the residential space, class (B) buildings usually attract a solid base of average working-class tenants.. These types of tenants are usually attracted to class (B) buildings since they might be priced out of the class (A) assets.
“It used to be that class (B) buildings would be around 10-20 years older than A buildings. I think now class (B) buildings have really evolved into 30-40 year old assets. I believe the lifespan of a class (B) building has been and can be extended with the proper capex improvements and preventative maintenance. After the 70s the quality of buildings really started to evolve. Windows were designed better. They tend to be double-pane or insulated windows. Siding evolved as well with technology on the residential side. But even for offices, the quality of building really started to ratch it up as we got into the 80s. Since the late 70s and 80s, it started to become a lot better.”
– Rohan Gupta
Lastly, you’ve got the class (C) buildings, which are the lowest classification. These buildings are the older buildings that need a lot of updating and potentially have a lot of deferred maintenance (older electrical systems or chillers) and numerous items that need to be repaired (which can cost a lot of money). Older buildings also have a tenant base, especially in residential, that might be less wealthy. Due to this type of tenancy, you can face some issues and challenges with rent collections (especially in states like California, where there are a lot of tenant protections and eviction moratoriums). Due to these reasons, class (C) building deals can be quite challenging if you don’t have enough adequate capital to improve and maintain the asset.
“You have to roll up your sleeves as you move down the scale from A’s to B’s to C’s.”
– David Fong
Why Does GoodLife Primarily Purchase Class B Buildings?
Since class (B) buildings are not as updated as class (A) buildings, they are more affordable. Due to the more appealing price tag, for investors, it presents opportunities to buy class (B) buildings or class (B-) buildings where there are opportunities to renovate the building and upgrade it into a higher class (B) building or even a class (A-) building. Since you’re able to buy class (B) buildings at a better value than the price of a class (A) building, there tends to be more upside if done correctly.
Rohan and David often try to find bridge lenders who are willing to lend based on the future renovations and higher rent GoodLife HP proposes to gain. At GoodLife Housing Partners, the ultimate goal is for Rohan and David to find class (B) buildings in class (A) locations where there’s a story.
“There are always all sorts of reasons why class (B) buildings or class (B-) buildings may not have reached their potential. For example, neglect in management or an absentee owner from out of state, and so that’s the opportunity for investor groups like ourselves to look at.”
– David Fong
Each class of property represents a different level of risk and reward. As an investor, it’s important to understand the differences between each building class to know what type of property you are investing in and the various conditions of the property. GoodLife Housing Partners often focuses on Capital appreciation, a rise in an investment’s market price, which is why Rohan and David primarily invest in Class (B) buildings.
Debt Coverage Ratio
In Episode 76 of the Investing with GoodLife podcast, Rohan and David discuss a term frequently used by lenders and institutional investors, Debt Coverage Ratio or Debt Service Coverage Ratio (DSCR). Rohan and David define the Debt Coverage Ratio and discuss specifically how it impacts them through their work at GoodLife Housing Partners.
Read on to learn more or you can listen to the episode using the following link. Investing with GoodLife is available on all major podcast platforms. https://anchor.fm/goodlifehp
Defining DCR
Debt Coverage Ratio is used in a number of ways. As a formula, it's your Net Operating Income (NOI), (Listen to Episode 73 to learn about NOI) divided by the Annual Debt Service (all the payments you have to make as a borrower under the loan).
If your NOI is the same as what you have to pay the lender for your loan for the coming year, then you're basically at a 1.0 Debt Service Coverage Ratio (DSCR). If this is the case, you won’t have much room for movement as all of your revenue from your investment will basically be used to pay your loan costs. If your loan revenues decrease or your expenses increase, you will not have enough funds generated from the asset to pay your monthly loan payment.
In last week's podcast episode, Rohan and David discussed Loan to Value, which is another metric lenders use to size up the amount of loan proceeds they'll give you. Once you get past Loan to Value (LTV), the next step in the lenders underwriting in determining your maximum loan proceeds is Debt Service Coverage Ratio (DCR or DSCR).
Understanding Lender's Relationship with DCR
To understand how DCR affects lender's calculations, a lender doesn’t want you to use 100% of the net operating income for your loan payments because if for some reason the net operating income goes down then the lender is exposed to financial risk. Lenders of course don’t want any risk, for the DSCR, lenders have a test they call the DSCR test. Lenders like to see a DCR number of 1.2 or higher. This means the revenue that you generate from a property is at least 1.2 times more than what you have to pay monthly on annually in debt service to the lender.
DCR or DSCR follows the same idea as LTV. It is an opportunity for professional investors to push returns, by getting higher leverage and to push the best DCR down. It’s important to remember that as an investor you must also have some cushion and be responsible, especially when things can get a little choppy. Having very high leverage amounts or a very low Debt Coverage Ratio can lead to some challenges or problems if cash performance at the asset declines.
What does it mean if your ratio is below one?
If your ratio is below one, that essentially means you're negative. From the revenue you're collecting on your real estate asset, you're not gaining enough money to cover your loan payments. This ultimately becomes a problem because then someone has to fund capital to make those loan payments or else you will be in default. You might have to make a Capital Call to your investors as a result (which nobody really wants to do). It is very awkward to go back to investors to say, "Hey, the property is not generating as much income as I thought, I need more from you before the lender gets mad at me". The worst-case scenario is the lender then forecloses on you and you wipe out you and your investor's entire cash investment in the real estate.
How GoodLife HP Thinks about DSCR
At GoodLife Housing Partners, when we look at investments, we are mindful of the DSCR. The lender looks at DSCR to figure out what kind of risk they will take. We need to look at it and figure out what kind of cushion or margin of effort do we want?
When we typically do value add transactions, we're renovating apartments and other units so the cash flow will typically dip due to vacancies while renovating a unit. It is extremely important to be mindful that you're not put in an awkward position where you can't cover your loan. Lenders don’t want to own the real estate also so that's why when they size loans so they can figure out what's the maximum they’ll give you in terms of loan proceeds. They look at Loan to Value and they also look at DSCR.
Overall, the Debt Coverage Ratio is a simple metric to explain or demonstrate how risky your project may be.
How Do Lenders Use Debt Service Coverage Ratio (DSCR)?
Lenders use Debt Service Coverage Ratio to also determine what the DSCR will be later on after your business plans are completed. For example, once you execute your business plans and the renovation plan is completed, and you know how rents will look like in the future, lenders want to make sure the new revenue is healthy enough that there can be a takeout lender who will be able to refinance you and pay off the current existing lender. The pay-off lender will be looking at the DCR once again to figure out how the property’s net revenues can cover the new loan payment.
In our business at GLHP, they check to see if we raised the income and make sure everything was verified.
The lender will look at the DCR and say something along the lines of, “Well on stabilization after your business plan is done, it looks like your Debt Service Coverage Ratio will be super healthy (1.3 or 1.4)”
If the lender believes the business plan is realistic and feels like you’re capable, and have the track record and skills to execute, then the lenders will get comfortable with that risk and they'll do that loan. If you get to 1.3 or 1.4 DSCR in the future, lenders know there'll be a market for other lenders to basically refinance them out and so again, it's a measure of risk and the pressure of where the revenues are currently versus where it needs to get to be in the future.
Moving Forward with DCR/DSCR
Ultimately in the commercial real estate business, DCR/DSCR is a good metric to use in your own analysis. A bank will always put your deal through this matrix. Having good knowledge of what that number is and how to calculate it is useful wherever you're investing. Additionally, when you’re choosing lenders, whoever you pick as a lender it’s good to know what their tests and risk tolerance is.
GoodLife HP Continues to Expand in Dallas, Texas
On February 17, 2022, GoodLife Housing Partners purchased the Centennial Apartments, a 100 unit multifamily apartment community located in the rapidly growing medical district of Northwest Dallas. “GLHP” feels very confident in delivering exceptional returns due to previous ownership’s conservative business strategy driven by fears of low occupancy during COVID‐19, rental rate upside has not been maximized despite the strong rent growth in the local market.
We are excited to start our comprehensive exterior and interior renovation program with an expected ~20% increase in net operating income (“NOI”) once completed. Further NOI can be generated by continuing the existing renovation scope for the remaining units, adding a smart home technology package to all units, washer dryers to select units, and developing additional exterior community amenities.
GLHP is actively acquiring class A-C multifamily, industrial, affordable, and student housing product between $10-100M in major metropolitan areas. GLHP is a Los Angeles-based, privately-owned real estate investment firm that has owned and operated over $400 million in assets. Our mission is to acquire quality assets, provide a high-end living experience for our residents, and generate value for our investors.
Net Operating Income
At GoodLife Housing Partners, we are always looking for ways we can increase our Net Operating Income (NOI). In Episode 73 of Investing with GoodLife, Rohan and David further discuss why NOI is an important metric that we are constantly using in our deal analysis. By the end of this article, we hope you know the following about NOI:
• Understand how to calculate NOI
• Ways to increase NOI
• GLHP’s Point of View on NOI
What is NOI?
NOI is a calculation used to analyze the profitability of income-generating real estate investments and is the standard metric used in the commercial real estate industry today. To define NOI simply, it is the net operating income or revenue generated from an investment (for example, rents plus other ancillary income), minus the top-line expenses (eg..general expenses incurred in operating the real estate asset such as taxes and insurance). NOI is ultimately a snapshot of the economic viability of a real estate investment. Even though NOI is not the final end-all-be-all of metrics in analyzing a real estate investment, it is a critical measure to consider because if you can increase the NOI of a real estate asset, you are able to increase the overall value of the property. This is because most investors today value and price real estate assets based on the property’s NOI.
NOI is a key component in many other valuable real estate metrics. For example, in Episode 72 (Linked at the bottom of this page), David and Rohan discuss how a Cap Rate is calculated by dividing net operating income by property asset value or purchase/sale price.
What isn’t included in NOI?
One important thing to keep in mind though is that NOI does not include *below-the-line expenses, the biggest ones being mortgage interest and other loan payments. As Rohan describes in the podcast, interest, and loans aren’t calculated in NOI because these factors are different for every borrower.
“The way I generally look at it is, the interest rate on a loan that Warren Buffet could get, versus the loan the average guy on the street could get, is going to be a little bit different.”
– Rohan Gupta
Even though NOI doesn’t take into account these expenses, as well as other costs incurred in the ownership of real estate, such as capital expenditures, it’s a much more precise calculation compared to simpler metrics such as GRM because it takes into account all revenue streams, while also accounting for most operating expenses.
How GLHP Believes NOI is Evolving
One thing changing, as the industry shifts, is insurance costs. While insurance costs used to be fairly fixed, today, insurance premium costs are on the rise all across the United States. For example, in Texas after multiple storms, tornados, etc. insurance prices have risen considerably in the last few years.
Because of this, owner-operators like Rohan and David, are always trying to find creative ways to reduce insurance costs. An example of how they are accomplishing this is pooling the insurance policies of separate properties together by using the same property management company’s master insurance program. This has led to savings of over 20% in many cases.
*below-the-line expenses: below the line refers to line items in the income statement that do not directly impact a firm’s reported profits and thus, the calculation of the NOI. For example, a firm may classify certain expenditures as being capital expenditures, thereby pushing them below the line by shifting them from the income statement to the balance sheet.
GRMs
What makes a good investment? Unfortunately, there is not one definitive answer. What might be a good investment for one person might not be a great investment for someone else, but thankfully there are some general guidelines that can help you make informed decisions about your investments.
In Episode #72: Cap Rates vs. GRMs of the Investing with GoodLife podcast, Rohan and David compare Cap Rates and Gross Rent Multipliers (GRM). They discuss the pros and cons of each and deliver a general understanding of what GRMs are. Read on to learn more or you can listen to the episode using the following link. Investing with GoodLife is available on all major podcast
What is GRM?
GRM or Gross Rent Multiplier is the ratio of the price of a real estate investment to its annual rental income before accounting for expenses, such as property taxes, insurance, utilities, Etc. GRM is the number of years the property would take to pay itself in gross received rent.
How Do you Calculate the GRM of a Property?
To calculate the GRM of a property, you divide the price of the property by its gross rental income.
Difference Between Cap Rates & GRM
The major difference between Cap Rates and GRM is that the GRM uses the gross income of the property, while Cap Rates use the Net Operating Income (NOI) of the property.
Pros of GRM
The biggest pro of using the Gross Rent Multiplier is how easy the metric is to use which allows you to calculate quickly. The GRM is quite effective since it allows you to easily compare potential investments and eliminate properties before performing in-depth analyses.
Cons of GRM
A con of using the GRM is that it only focuses on rental revenue and excludes other revenues that can be generated from a rental property. Another downside of GRM is that it doesn’t consider vacancies or other expenses, such as property taxes, general operating expenses, maintaining common areas, roof maintenance, etc. Since none of those are considered in this metric, it contrasts to Cap Rates as Cap Rates are based on NOI, and Net Operating Income is defined as revenues minus expenses.
What Are Cap Rates?
As a real estate investor, you are always looking for the next great opportunity. You may have heard about cap rates and how they can affect your bottom line, but what are cap rates and how can you use them to your advantage? On episode #71 of the Investing with GoodLife podcast, Rohan and David discuss cap rates and their numerous benefits. Read on to learn more or you can listen to the episode using the following link. Investing with GoodLife is available on all major podcast platforms.
Understanding Cap Rates
According to Investopedia, "a capitalization rate is used to indicate the rate of return that is expected to be generated on a real estate investment property. This measure is calculated by dividing net operating income by property asset value and is expressed as a percentage." Basically, cap rates are a valuation metric and one of the many factors to consider when conducting a financial analysis of an investment.
As you go up the investor scale, cap rates become the most used and simple measure of how people evaluate real estate. Cap rates make it easy to compare properties regardless of the investment type and it's usually the first thing we look at here at GLHP. Whether you're buying a multifamily property in Dallas, or you're buying a strip center in Orlando, it almost doesn't matter because cap rates help categorize different investments into the same bracket.
Reasons for Using Cap Rates
Cap rates are like stock market predictions or any other formula used to look at stocks or evaluate stock speed. If the property is seen as being riskier, the cap rate will be higher in order to compensate the investor for taking on that additional risk. Additionally, If the market is doing well and investors are eager to invest in property, the cap rate will likely be lower. This is because investors are willing to pay more for a property when there is more demand for it. In essence, cap rates provide a sense of value- this is where you get your baseline number. This formula is used to make a rapid analysis of whether you should pursue an asset or pursue something else.
Institutional Property Advisors Brokers the Sale of Two Multifamily Assets in North Tempe
TEMPE, Ariz., June 15, 2021 – Institutional Property Advisors (IPA), a division of Marcus & Millichap (NYSE: MMI), announced today the sale of 134-unit Sakara Tempe and 36-unit Sakara Villas at Tempe in Tempe, Arizona. Together, the properties sold for $30.5 million, which represents $178,363 per unit.
“Located at the doorstep of Arizona State University, these garden-style apartment communities offer two of the remaining cost-effective price points near campus,” said Cliff David, IPA executive managing director. “Residents enjoy more favorable rent economics in comparison with the towering purpose-built student housing alternatives and traditional Class A market-rate communities that surround the properties and permeate North Tempe. Sakara’s rent affordability measured against North Tempe’s best-in-class housing stock and the nearly 70,000 employees and 2,000 total business in the surrounding area make it ideal for the implementation of a comprehensive renovation strategy.” David and IPA executive managing director Steve Gebing represented the seller, GoodLife Housing Partners, a student housing and apartment investment firm based in Los Angeles, California founded by principals, Rohan Gupta and David N. Fong. Cliff David and Steve Gebing also procured the buyer, Capital Allocation Partners, Nathan Reid, principal.
“We are truly excited about the sale of the Sakara portfolio as it represents a successful exit and execution of our value-added renovation business plan for the property after acquiring it three years ago for approximately $20.8 million,” stated Fong.
Built in 1968, the properties are within walking distance of Arizona State University and the University Drive/Rural Road Transit Center. There is over 4 million square feet of retail and dining within a three-mile radius of the communities, including Downtown Tempe, Tempe Marketplace, and Mesa Riverview/Sloan Park. Loop 202, Loop 101, and U.S. Route 60 are also within three miles of the two properties.
Sakara Tempe and Sakara Villas at Tempe feature one-, two- and three-bedroom apartment homes. Select apartments have new laminate kitchen countertops, wood-style vinyl flooring, and two-tone paint with accent walls. Some of the units are furnished for the convenience of students. Common area amenities at Sakara Tempe include a resort-inspired swimming pool with cascading water features and poolside cabanas, a fitness facility, bocce ball court, and an outdoor television lounge
Newmark Announces Sale and Financing of 416-Unit Multifamily Asset in DFW Market
Newmark announces the sale and financing of Marbletree Apartments, a 416-unit, garden-style multifamily asset at 4057 North Belt Line Road in Irving, Texas. The property is currently 98% occupied.
Newmark Senior Managing Director Jakob Andersen and Executive Managing Director Brian O’Boyle, Jr. represented the seller, LumaCorp, Inc., in the transaction to buyer, privately held real estate investment company GoodLife Housing Partners (GoodLife HP). Financing for the purchase was provided by Ready Capital and placed by Newmark Vice Chairman Deverick Jordan, MAI, FRICS and Associate William Hairston.
“This was a cooperative effort, with value added for all parties. The transaction was executed in a timely manner and facilitated a 1031 exchange for the seller; the buyer is able to expand their footprint in the Dallas-Fort Worth market,” said Brian. “Additionally, the transaction demonstrated the health of the debt capital markets,” added Deverick.
“Our objective as the lender was to provide the sponsor with an optimal loan structure to match their business plan. We were able to meet their timeline with certainty of execution through our upfront process,” said David Cohen, Managing Director of Ready Capital.
Built in 1982 and having never undergone renovations, the property is well-positioned for capital improvements, including updated unit interiors and improved property amenities, which is in-line with the Buyer’s value-add investment strategy.
The property is located less than two miles from Dallas-Fort Worth International Airport and has direct access to Interstates 161 and 183, providing residents a convenient 20‐minute drive to Dallas Love Field Airport, Downtown Dallas and Downtown Arlington, and a 30‐minute drive to Downtown Fort Worth. There are 185,227 jobs within a five‐mile radius of Marbletree Apartments and several new major employment hubs are under development nearby, including Las Colinas Urban Center (26,000+ employees), American Airlines headquarters (11,000+ employees) and Cypress Waters (17000+ employees).
According to Newmark Research, despite the impact of COVID‐19, annual rent growth for 1980s vintage multifamily assets in the Irving submarket remained positive at 2.4%. In the past five years, the average annual rent growth has been 4.2% and the average occupancy rate has been 95.2%, reflecting the strength of the submarket.
About Ready Capital
Ready Capital (NYSE: RC) is a multi-strategy real estate finance company that originates, acquires, finances and services small- to medium-sized balance commercial loans. Our National Bridge Originations Team offers nonrecourse financing on transitional, value-add and event-driven commercial and multifamily real estate opportunities. Ready Capital is a direct lender that provides comprehensive financing solutions to real estate owners, investors and small business owners, which generally range in original principal amounts between $2 – $45 million and larger for select assets and portfolios. For more information, contact David A. Cohen, National Bridge Originations Managing Director for Ready Capital at david.cohen@readycapital.com.
About Newmark
Newmark Group, Inc. (Nasdaq: NMRK), together with its subsidiaries (“Newmark”), is a world leader in commercial real estate services, with a comprehensive suite of investor/owner and occupier services and products. Our integrated platform seamlessly powers every phase of owning or occupying a property. Our services are tailored to every type of client, from owners to occupiers, investors to founders, growing startups to leading companies. Harnessing the power of data, technology, and industry expertise, we bring ingenuity to every exchange, and imagination to every space. Together with London-based partner Knight Frank and independently owned offices, our 18,800 professionals operate from approximately 500 offices around the world, delivering a global perspective and a nimble approach. In 2020, Newmark generated revenues in excess of $1.9 billion. To learn more, visit nmrk.com or follow @newmark.
Discussion of Forward-Looking Statements about Newmark
Statements in this document regarding Newmark that are not historical facts are “forward-looking statements” that involve risks and uncertainties, which could cause actual results to differ from those contained in the forward-looking statements. These include statements about the effects of the COVID-19 pandemic on the Company’s business, results, financial position, liquidity and outlook, which may constitute forward-looking statements and are subject to the risk that the actual impact may differ, possibly materially, from what is currently expected. Except as required by law, Newmark undertakes no obligation to update any forward-looking statements. For a discussion of additional risks and uncertainties, which could cause actual results to differ from those contained in the forward-looking statements, see Newmark’s Securities and Exchange Commission filings, including, but not limited to, the risk factors and Special Note on Forward-Looking Information set forth in these filings and any updates to such risk factors and Special Note on Forward-Looking Information contained in subsequent reports on Form 10-K, Form 10-Q or Form 8-K.