Please enjoy an excerpt from the Fall issue of The Linneman Letter by Dr. Peter Linneman, PhD, Chief Economist for NAI Global and Principal of Linneman Associates. Mr. Linneman will also be the featured speaker of the upcoming 2017 NAI Florida Forum.

“How “at risk” are different property investments to an economic downturn? To address this question, we examined a variety of simplified investment profiles. Specifically, we simulated the returns for an 8-year hold period for 3 hypothetical multifamily investments: a class A property with a low yield and high NOI growth in a Gateway market (“Gateway A”); a class A property with a mid-range yield and medium NOI growth in a secondary market (“Secondary A”); and a class B property with a high yield, but low NOI growth, in a tertiary market (“Tertiary B”). We chose to model multifamily because of the simplicity of mark-to-market rents, though our insights can be generally applied to other property types. Each investment is analyzed for a Base Case with constant (but different for each property) NOI growth. For all investments, we assume a purchase price of $100 million, cash flow margins of 83% of NOI (reflecting on-going capex), and exit transaction fees of 3%.

The Gateway market A investment has a going-in cap rate of 4%, NOI growth of 4% per annum for 8 years, and an exit cap rate of 4.5%. The Secondary market A investment has a going-in cap rate of 6%, NOI growth of 2.5% per annum, and an exit cap rate of 6.5%. The Tertiary market B investment has a going-in cap rate of 7.5%, NOI growth of just 1.5% per annum, and an exit cap rate of 8%. For each property, we overlay 3 leverage scenarios: no leverage, 50% LTV, and 75% LTV. This yields a total of 9 “Base Case” scenarios. In both the 50% and 75% LTV scenarios, we assume 10-year debt with a 3.5% interest rate and 30-year amortization.

We also simulated how returns and (interest and debt) coverage ratios are affected by reduced NOI growth due to a cyclical downturn. We refer to these 9 scenarios as the “Realistic” scenarios, as NOI never grows smoothly upward forever. These scenarios assume -6% NOI growth in years 3 and 4 (that is, an aggregate 11.6% NOI decline spread over 2019 and 2020) of the investment horizon. Thereafter, the originally modeled growth rates resume through year 8. In total, we simulated 18 investment scenarios and their corresponding return profiles: 3 different investments, with 3 leverage ratios and 2 economic environments.

While highly simplified, this analysis is fairly realistic and provides insights on the impacts of leverage, property type, and the economy. As to leverage, as long as original pro-forma growth occurs, increased leverage increases both the equity IRR and the equity multiple. For example, the Gateway A property generates an equity IRR of 5.2% with no leverage, 6.3% with 50% leverage, and 8.5% with 75% leverage, while the equity multiple increases from 1.4x to 1.6x to 2.0x over the 8 year hold.”

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