Winning the Deal


Brian D. Milovich

Managing Principal, Calvera Partners

During my MBA program at UC Berkeley, I read The Real Estate Game by William Poorvu. Mr. Poorvu was a real estate investor and professor at Harvard Business School. This book got me excited about real estate because it had real-life deal examples. It also demonstrated the power of “back-of-the-envelope” analysis. I loved the simplicity of it. Additionally, if you had creativity or a vision, it showed that immense value could be created. The book, published in 1999, still remains relevant.

Today, real estate investing is wrapped up in Excel spreadsheets. Investors become economists and believe they can predict interest rates and rent growth. They also think the more complex the model, the easier it is to justify an improbable assumption. Presenting eye-popping investment returns and distribution yields are the norm—because the model said so. Many investors have forgone common sense, cash flow-based models, and opted to rely on appreciation. It’s also because if they don’t, someone else will.

That last part is what I find difficult. Plugging in outlandish assumptions solely to win the deal. I’m not talking about a renovation plan someone is confident in executing. Or industry standard replacement reserves of $300 when they run much higher than that. And I’m not even criticizing those who use bridge debt when the business plan calls for it. It’s when investors decide to plug their nose, close their eyes, and hope for the best. Who does this serve? Only those putting out the money to generate fees. It certainly doesn’t help the underlying investor.

This line of thinking worked when everything went up in value. In 2021, why not assume 15%+ rent growth for the next two years? Inflation was trending that way. Everyone was a master value-add operator. To win the deal, you not only had to pay a low cap rate (3%), but your rent growth was also off the chart. And, you had to sell it in 2-3 years at those same low cap rates after everything went according to plan. That’s because a refinance wouldn’t be possible. It’s not a surprise that these deals are now distressed.

In 2021, we looked at hundreds of deals. We bought only one deal that year because nothing made sense to us. That one deal had a loan assumption at 4.13% (a high interest rate at the time) that was fixed for 9 more years. Because nobody wanted that loan and its 64% LTV, we paid a 5-cap when everyone else was paying in the 3s and 4s. We did this before inflation increased rents in the submarket. Outlandish assumptions weren’t needed to make this work.

Who pays for this pending mess of distress, both literally and figuratively? It should be the sponsor. During the GFC, an investment manager lost $1 billion for a pension fund in a bad land deal. The manager subsequently resigned. My sense today is that not much will happen to these sponsors. Perhaps some will look for a new line of work. Others (larger firms) will talk about “deep relationships” with their investors. They’ll say it wasn’t their fault, that everyone was doing it. And they’ll continue raising money as if nothing happened.

This all could’ve been avoided by focusing on cash flow instead of momentum. Simple metrics like stabilized yield or return on cost would’ve shown investors how foolish their underlying assumptions were. Thankfully, cash flow is back in vogue today. There’s a renewed focus on underwriting basics. Higher interest rates are forcing investors to pay more attention to risk.

I also hope we return to an environment where a premium is placed on execution. Sponsors who are great at renovating units, uncovering burgeoning submarkets, or finding operating efficiencies should return to the forefront. If you have confidence in your ability to improve cash flow, then a complex model isn’t necessary. If a prospective deal can’t pass a “back-of-the-envelope” test, then it doesn’t matter what gets plugged into the model. Let performance, not leverage, be the arbiter of a top investor.


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