How I Build an Investment Thesis

release edition [093]

read time [8 minutes]

Welcome to The Multifamily Download, a weekly newsletter where I provide institutional insights to help you build an exceptional Multifamily career.

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Today at a Glance:

• Convergence: The Five Forces
• Thesis: My Thought Process
• NMHC: Sentiment Survey
• Weekly Listen: CBRE

The Five Forces

Last week I wrote about the five forces in Multifamily that appear to be converging at the same time: supply, demand, the maturity wall, distress, and demographics.

And, I made the argument that market timing matters more than we're all willing to admit, especially as these five forces are appearing simultaneously.

Today, I'm going to answer the natural follow up question, which is "So, what should I do with all this information?"

Before I get to my answer below, here's a quick snapshot showing where each of these five forces sit as of this week.

First, let's start with interest rates. After running up nearly 80bps from 4.37% to 5.29% over the last few months, the 10yr UST rallied yesterday to close just under 5%, with the 2-year just under 4.7%. The effective Fed funds rate is sitting at 3.88% after September's hike.

Now let's look at the balance sheet. As I wrote about recently here on LinkedIn, CRED iQ re-sized about $136 billion of Fannie, Freddie, and CMBS apartment debt maturing between October 2026 and December 2028.

According to the CRED iQ's findings, roughly a quarter of those loans, holding 31% of the balance, are short on equity at today's rates, creating a gap of about $6.8 billion. The September hike alone pushed 178 more loans below a 1.25x DSCR. The median shortfall works out to roughly $25,000 per apartment.

And the pain is not evenly spread with 2021 and 2022 vintage acquisitions accounting for 57% of the short balance, while only 15% of 2016 to 2018 originated loans are in need of liquidity.

Distress is trending up once again. The Multifamily CMBS delinquency rose 35 basis points in September to 8.04%, per Trepp, up about 145 basis points in one year.

Despite the Capital Markets and capital stack headwinds facing many operators today, asset-level fundamentals are improving. Yardi has national rents up 0.3% in the third quarter, the first positive Q3 in four years, and up 1.4% year to date.

Occupancy has gained 50 basis points since January. Gateway and Midwest markets are leading, including San Francisco, New York, Chicago, Kansas City, Detroit, while Austin, Houston, Denver, and Tampa still work through their bouts of elevated supply.

Higher rates are a headwind for balance sheets and a tailwind for rent rolls, because they strangle the new construction that would otherwise compete with existing Multifamily properties.

The TL;DR is this: Rents are improving while the financing is not. This is the conundrum facing Multifamily owners and operators in 2026.

Summary

The five forces are converging in real time. Both debt and equity are expensive, the refi gap is real and concentrated in the 2021-22 vintage, distress resumed its climb in September, and rents appear to be improving underneath it all. The tension between better property fundamentals and a worse balance sheet is the conundrum facing many Multifamily owners heading into 2027.

Actionable Takeaway

Equity investors today are requiring Multifamily sponsors to play offense and defense at the same time. Before presenting your next investment opportunity to equity, ensure that you can clearly articulate both the downside protection mechanisms and risk mitigants, as well as the growth and upside. Both are required to get equity off the sidelines today.

Building A Thesis

Forming a thoughtful investment thesis in a volatile and cyclical market environment like we're experiencing today is not easy.

I don't pretend to have all the answers, but what follows is my attempt to distill how I have gone about forming an investment thesis, so I hope it's helpful.

1/ Identify asymmetric opportunities.

In short, aim to invest in markets that have a disproportionate ability or likelihood to outperform to the upside with a limited risk or likelihood to underperform to the downside. Ideally, this should include both the market fundamentals and an operator's unique advantages working synergistically over the life of the investment period.

2/ Utilize inverted thinking.

As the late Charlie Munger said, "Invert, always invert". Munger believed that avoiding stupidity and failure is often much easier and more reliable than trying to be brilliant. Rather than thinking about why something is a good idea or destined for success, invert the thought process to ask opposing questions such as "How does this not work?" or "What could happen to cause a total loss of capital?"

3/ Study historical trends.

Understanding how a market has behaved in past cycles can offer a glimpse into how it may perform in the future. History rarely repeats itself, but it often rhymes. As an example, Phoenix is historically a boom-bust market for equity investing in Multifamily.

4/ Begin with the end in mind.

Selecting key market-level assumptions will help eliminate confirmation bias once a specific deal has been identified in a market. For example, study and select an exit market cap rate for your investment strategy before underwriting any deals will ensure that returns are the output of a strong basis and business plan, not a tighter-than-market exit cap rate assumption. If the untrended yield on cost does not exceed the exit cap by 125 basis points or more, then the asset may be too reliant on the market to generate returns.

5/ Use reasonable assumptions.

The refinance gap mentioned above is $6.8 billion for a reason. Too often, deals use a stretch Senior loan to justify the price rather than using the price to justify the loan. I covered the three honest ways to live with negative leverage in TMD 091, so I won't repeat them here. The thesis-level point is simpler: the financing has to be accretive to the business plan, and should not be the variable that makes the underwriting or business plan work. If the capital stack only works at max leverage over a specific hold period then it's likely overly sensitized to the debt structure.

6/ Sensitize realistically.

Two great ways to avoid the risk of ruin are as follows: (a) solve for average cash on cash returns over a modeled hold period that equates to 40% or more of the total expected return, and (b) a conservative refinance take out sizing such that a refinance can be executed during the hold period if the market environment isn't conducive for selling when the hold period ends. Real Estate is not a game to be won, but a game to be survived. The goal is always to be default alive.

Summary

Hunt for asymmetry first, invert to find stress points, and let history be a guide. Then, select an exit cap before underwriting, keep the financing accretive and moderate, and size the downside so you can survive an extended hold period. Built this way, the returns come from the basis and business plan, rather than from market forces that may or may not be supportive.

Actionable Takeaway

Pull your most active deal and test the two numbers that decide it. First, set the exit cap at or above today’s market before you touch rent growth, and confirm the untrended yield on cost clears it by at least 125 basis points. Second, check that average cash on cash covers 40% or more of the total return, and that a refinance could take you out mid-hold if a sale is not an option.

NMHC Survey

NMHC's October survey shows that the people running the biggest apartment firms see things similarly to what I've just described above. The survey polls 130 CEOs and senior executives, and it runs on diffusion indexes where 50 means no change from last quarter. Anything under 50 means conditions got worse.

Three of the four readings were extremely disconcerting.

Debt Financing came in at 10, down from 46 in July and 78 a year ago, with 81% of respondents saying it is a worse time to borrow than three months ago.

Equity Financing landed at 17, where two-thirds reported capital is harder to find.

Sales Volume sat at 22, with 61% of respondents seeing lower deal flow.

Then there is the one number that held. Market Tightness came in at 47, a hair under breakeven and up 16 points from a year ago.

Said differently, the operating side of the business is close to steady while the capital side is frozen solid.

That is the same conundrum that I mentioned above; improving rent rolls and frozen balance sheets.

My biggest takeaway is this: A frozen transaction market is a pricing opportunity for anyone who can close. When 66% of firms say equity is harder to find and 81% say debt got worse, the buyer field quickly thins to whoever has available or discretionary capital.

Summary

NMHC's October survey put debt financing at 10, equity at 17, and sales volume at 22, all well below breakeven, while market tightness held near 50. The capital markets froze while fundamentals held, according to the 130 CEOs that were polled.

Actionable Takeaway

If you have committed equity and an investment thesis or business plan that can be justified in the face of ~6% interest rates than this is the time to be aggressively submitting LOIs because 130 executives just told NMHC they can't fund or finance a deal right now.

Weekly Listen

This week's listen is “Should I Stay or Should I Go: Timing Capital Deployment” on The Weekly Take from CBRE, where host Spencer Levy sat down with Devin Chen and Rich Hill of Principal Asset Management.

Their perspectives pair nicely with today’s issue. They argue the repricing is mostly behind us and that future returns will come from NOI growth, not cap rate compression, so the deals that win are the ones you can defend on income and basis.

Chen’s advice to stress-test every deal for both downside and upside, and to steer clear of the over-leverage that forces a refinance into a bad loan market, are essentially straight out of the framework I outlined above.

You can listen to the full episode here.

Wrap Up

That's it for today. I hope you found this edition of The Multifamily Download insightful.

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Thanks for reading. See you next week!

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