As we enter a new year, real estate markets are changing fast and investors should look for ways of gaining a Margin of Safety

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Creating a Margin of Safety


When considering investing as a limited partner don’t overlook the project’s fundamentals.  It’s important to understand a project’s return on cost, the debt service coverage ratio and ways of finding your “margin of safety.”

Have you ever wondered why so many good real estate investments go bad?

In today’s economy a lot of people are making good money investing in real estate.  There are new crowdfunding sites popping up almost every day, posting yields in the high teens to over 20%.

What makes me so nervous is that many investors are chasing IRR’s and have lost sight of maintaining a “margin of safety” based on a project’s return on cost and debt service coverage ratio “DSCR”.  The return on cost and debt service coverage ratio (DSCR) is the backbone that professional underwriters of commercial real estate  use to determine the right LTV along with their relative equity position in the capital stack, when assessing their risk.

So how does one use the DSCR to find a relatively safe position in the capital stack?

Here is an example of how you can better underwrite and perhaps negotiate a margin of safety using just a few data points from information posted in a project’s proforma.

Assume you are considering investing in a garden apartment project.  One property is ten years old and only needs minor upgrading.  The other property is a new, to be built apartment project in the same market.  The investment term for each is estimated to be five years. The purchase price for each is $20,000,000 based on a net operating income of $1,000,000.  The exit sales price in year five is estimated to be $24,000,000 for both properties.  The IRR is engineered by the waterfall to achieve an estimated 18% for both deals.

Now let’s look at an example of how you might be able to increase your margin of safety.

For the existing apartment, the cost and the purchase price, is the fair Market Value $20,000,000.

For the new construction apartment, the Market Value is $20,000,000, however the cost to build is only $18,000,000.  The developer is offering the project to the LLC at $20,000,000, but will defer his $2,000,000 construction profit until the property is sold in the fifth year.

By comparison, for the new construction, let’s assume that a lender would make a 60% loan ($10,800,000) for the $18,000,000 construction cost with interest only payments at a 4.5% rate.  The DSCR would be 2.05.

The debt on the existing property at 60% LTV would be $12,000,000 @ 4.5% and the DSCR is 1.85.

As a preferred equity holder in both deals, you are entitled to get your investment capital back, plus your preferred return, before the Sponsor gets their investment back.  With the new construction project, the developer has both his capital and his construction profit subordinated to the preferred equity holders, therefore, by pushing the builders profit to the end of the investment period, you have achieved an additional “margin of safety” built into the deal.


Let us know if you have any ideas of how to increase your margin of safety.


Happy Investing in 2018