It is admittedly difficult for me to not write about the effects of the current immigration and tariff regimes on our world as a real estate investment company. Their impact is pervasive in nearly everything we are experiencing on a daily basis—affecting decision making, resulting in reassessments of business plans, and creating substantial stress across the industry. The long-term unintended consequences will be sizeable, especially as it relates to immigration.
However, since we’ll be discussing these topics during our quarterly investor call next week (click here to register), I’ll spare the duplication and shift focus from the current disarray and instead turn to another subject that’s long been a personal frustration of mine: a lending and investment paradigm that, while widely accepted, often defies logic.
Setting the Stage
Imagine two multifamily properties:
- Each has 300 units, the same construction quality and location, and sits in the same metro area.
- Average rent is $1,000 per unit, with 10% other income and an expense ratio of 50% of gross potential rent.
The only difference? Occupancy.
- Property A is 94% occupied—about market average
- Property B is 88% occupied, struggling due to weak management.
Both properties are for sale at the same 6.5% cap rate.
Mathematically, Property A generates $237,600 more annual revenue and an equivalent increase in NOI, creating a 3.6 million price difference between the two.
Assuming max debt is desired, available debt is limited by either loan to value percentage (LTV – 80% for agency financing) or debt service coverage ratio (DSCR – 1.2 for agency financing). Using a 5.5% interest rate, with the performance inputs outlined above, in both scenarios the properties are slightly limited by DSCR so they don’t reach the full allowable LTV, but close.
As a buyer/investor, which property would you want to purchase?
Purely from a numerical perspective assuming no change in performance going forward, the returns are effectively identical. So, no real preference, right?
The agencies—Fannie Mae and Freddie Mac—won’t lend on properties with occupancy below 90%, which means agency financing—the most common source of multifamily loans—is off the table for purchasing Building B. Institutional investors, particularly those deploying capital from their Core or Core+ strategies, are similarly reluctant to participate. Both lenders and equity partners often view lower occupancy as an outsized risk—so much so that agency lenders won’t finance it at all.
But is it truly more risky?
A similar, though certainly different, situation occurs with bank lenders. As many readers know, Altus often makes investments with substantial value add efforts required. Those value-add efforts should (and generally do) result in substantially higher market value after the value-add than at the time of the original purchase. A big part of producing strong investment returns is the post value-add refinance or resale. Unless driven by a large investor’s preference to sell, Altus generally favors long-term investment and ownership—typically opting to refinance upon project completion rather than exit.
Yet when we approach the existing lenders to discuss the refinance—especially banks with portfolio loans—we’re often told that our refinance proceeds are at best limited to a percentage of our costs in the project, even if the result is a substantially higher DSCR or lower leverage than their normal lending requirements. However, that same lender will frequently offer maximum leverage to a new buyer coming in, often even encouraging us to refer them to potential buyers, even if that buyer is not a professional real state operator.
Why? Because the bank perceives a new buyer coming in at higher leverage (based on the new higher market value) and bringing “fresh cash” to the table as less risky, even though the operator with proven performance and full knowledge of the asset poses a lower true risk.
Backward Logic
Reverting to our two-property example, there is more logic in the bank limitations in the second scenario than the agency lender limitations in the first scenario, but just barely.
If we go to the extreme and assume the properties are being purchased (and valued) at 99% occupancy, the lender would be willing to increase their loan proceeds (in practice they generally won’t assume more than 95% occupancy). This means they are lending considerably more dollars on effectively the same asset. But the likelihood of Property A maintaining 99% occupancy is much lower than the likelihood of Property B maintaining 88% occupancy. In fact, with the market occupancy being 94%, if the operator has any level of management skill, Property B is likely to see increased occupancy, at least back up to market averages. And for Property A, even if the operator has considerable skill, it will be difficult to maintain the ultra-high occupancy. Property A is basically priced to perfection, while Property B is priced such that there is substantial upside in cash flow (and thus value). It then follows that Property A is more likely to see a reduction in cash flow and value, while Property B is quite likely to see an improvement.
The result is that the lender ends up with less debt service and equity coverage on Property A, and more on Property B. Mathematically, if Property B recovers only to market averages, the leverage drops to 70% and the DSCR improves to 1.37, both substantially lowering the risk for the lender. The same holds true for the investor. There is a much higher likelihood of improvement in their returns from Property B than Property A, and a higher likelihood of return reductions from Property A than Property B.
In scenario #2, the bank assumes that because the new buyer has more “skin in the game,” they’ll be more motivated to keep the loan current. The bank views newly contributed cash as more meaningful than the equity created through value-add improvements—even though that equity reflects real work and becomes realized value upon sale. Ironically, if we were to sell the property and immediately purchase an identical, neighboring asset with the sale proceeds, the bank would offer us higher leverage on the new purchase. Whether the cash from a sale is more meaningful than retained equity is debatable—and we clearly know which side of that debate we land on. But regardless, the bank overlooks a key distinction: the current owner is intimately familiar with the property, is directly responsible for its strong performance, and HAS NO DESIRE TO SELL!! A new buyer, on the other hand, lacks this operational knowledge, is purchasing from someone who may have reasons for exiting, and has yet to prove they can manage the asset to the same standard as the existing operator.
The Operator’s Advantage
What both scenarios have in common is that the lenders/investors are trying to avoid risk but instead end up taking on more risk; completely antithetical to their goals. While I believe lenders consciously understand that different operators have varying degrees of ownership skills—or at least they give lip service to this understanding—their actions and decisions show a blind spot in a true belief of this reality.
But as an operator, a reality it is. By definition, market averages are a compilation of performance across a broad swath of properties. Some properties perform above market. Some perform below market; and some far below. As asset managers, performing to market average is not an acceptable stabilized performance. We know that there are some terrible owners/asset managers out there. They are dragging down the mean. Over time, as we are able to impact performance (it doesn’t happen overnight) we absolutely should be able to outperform the market. And as transactional data becomes more available, and valuation information more ubiquitous, investment outperformance will depend more and more on execution, most of which is specific to asset management.
Thinking Beyond the Market
To outperform the market, investors must first think differently than the market. Understanding and challenging flawed risk perceptions is the starting point.
For lenders and investors alike, recognizing that real risk lies not in numbers, but in execution may be the most overlooked truth in our industry.
Happy Investing.
