This piece by Rob Beardsley was originally published on Lone Star Capital.
Synergies are a cliché in the M&A space. Throughout Warren Buffet’s annual letters to Berkshire shareholders, he often denounces the purported benefits of synergies associated with an acquisition or a merger. Buffet said, “we also never factor in, nor do we often find, synergies.” I can’t find the quotes, but I’ve read letters where Buffet joked about the “synergies” that helped an acquisition make financial sense only for that target company to be spun out of the parent and advertised that removing the subsidiary from the parent would unlock great potential and therefore the company is worth more on its own.
In real estate, however, synergies can be very real. For example, if you own a portfolio of properties all near each other, you can lower your overall payroll costs by sharing employees amongst the properties. Another example would be utilizing a master insurance policy across a portfolio to lower insurance costs. Lastly, you can use a larger number of units to negotiate better pricing with service providers for things such as trash removal, property management software, and advertising.
While these are all straightforward ways to benefit from synergy in multifamily operations, they aren’t always so simple to underwrite. Aside from the experience and due diligence required to identify such opportunities, there is also the need to conservatively adjust the numbers to reflect reality. The main concept in question is this: if the market values a property based on its standalone payroll being $1,400 per unit, but you’re able to underwrite payroll at $1,100 because you own a property next door, what is the true value of the property?
The problem occurs in the projected exit when you use $1,100 per unit for payroll and essentially overstate the “market” NOI for the property and use the “market” exit cap rate to project future sale value. The reason for this problem is that the market of buyers will not underwrite the $1,100 per unit payroll number and instead will use market payroll of $1,400 thus reducing the property’s value. This doesn’t invalidate the proposed synergy it just points out the fact that this form of payroll synergy doesn’t create terminal value or affect the future sales price.
While you own both properties, you get to enjoy lower expenses and better cash flow but if the properties are sold individually then there is no benefit derived from synergy upon sale. However, if you can productively merge the operations of the two properties and sell the properties together, then you will have created capitalized value since the market will pay a price for the two properties together reflecting the reduced expenses. If you identify opportunities for permanent synergy certainly those should be factored into your underwriting. The question becomes, “should you underwrite synergies if they aren’t permanent and won’t affect future sale price?”
I believe the answer is yes since you want to accurately reflect your projected operations. However, the exit price needs to be adjusted to reflect marketing underwriting/valuation. This can be done by adjusting the terminal operations to reflect market expectations (removing synergies) and determining the sale price based on this adjusted NOI. You can bring your synergy expenses back in and adjust the exit cap rate so that the projected sale price equals the one derived from the more conservative, adjusted NOI. This methodology will allow you to capture the upside of operational synergies without overstating the projected sale price, which often has a very strong impact on projected returns (which if overlooked, could cause you to overpay).