The process of underwriting or assessing a possible deal is still mostly mysterious to many first-time real estate investors. When people hear “underwriting,” they picture a laborious and difficult procedure. Underwriting a multifamily property acquisition is very simple. However, this is not always the case. Underwriting is the process of analyzing a deal’s financials to ensure they meet investment goals.
We’ll walk you through the process of underwriting and assessing a multifamily property deal, step by step. More precisely, we’ll discuss the following:
- Introduction and Hypotheses
- Multifamily Underwriting Step 1: Verifying Rents
- Multifamily Underwriting Step 2: Verify Operating Expenses
- Multifamily Underwriting Step 3: Identifying the Worth of a Property
- Multifamily Underwriting Step 4: Return to Continuous Financing Availability
- Multifamily Underwriting Step 5: Verify Acquisition / Restoration Financing and Budget
- Multifamily Underwriting Step 6: Project Cash Flows and Investment Standards
- Bottom Line
Introduction And Hypotheses
Underwriting serves the same overarching purpose regardless of the nature of the agreement, as previously noted. That is, before committing to a contract, investors assess whether or not the expected return will be sufficient to meet their goals.
Nonetheless, underwriting procedures are unique for each kind of business transaction. Different factors must be taken into account depending on the investment type, such as when purchasing a stabilized apartment complex versus creating a property from the ground up. Just as the incorporation of investors seeking historic tax credits or other nontraditional equity partners can add complexity, so can this.
Here, we shall outline the fundamentals of underwriting a multifamily property transaction. The underwriting of a multifamily apartment building’s A) purchase, B) value-add rehabilitation, C) subsequent stabilization, and D) will cover ultimate resale in detail. Since we think people are living in the building now, we will have to renovate the units in stages.
Multifamily Underwriting Step 1: Verify Operating Expenses
Before undertaking the underwriting process, investors in multifamily properties must first project operating results. Pro formas are forecasts of future operating results that investors can use to make educated guesses. It is also suggested that you start with the headline data, namely the rents.
Investors need to verify the specifics of each unit before attempting to collect rental data (e.g., square footage, current rent, current lease terms, historic vacancy, etc.). Investors need to estimate a premium above these rents to account for value addition. For instance, if all of the apartments in a building are renovated, the landlord may be able to charge twenty percent more each month for rent. For investors, this means anticipating rental income from the moment of purchase to the end of the rehabilitation process. It means raising rents from the pre-renovation levels to the post-renovation levels individually once units are completed. In addition, the pro formas need to account for both the escalating costs and the stabilized outcomes.
Multifamily Underwriting Step 2: Confirm Operating Expenses
Investors need to add estimated operating expenses to their pro formas after projecting rent results through the rehabilitation to the stabilized phase. Again, reviewing past performance can shed light on the current situation. By analyzing the past three years of electric consumption, for instance, we may make rather precise predictions of electric consumption.
Operating costs for a multifamily complex might take many forms, but some constants exist. The following costs are typical examples for apartments:
- Property management fees
- Accounting fees
- Marketing fees
- Property taxes
- Insurance
- Utilities
- Maintenance
Most of these costs won’t change much between the rehabilitation and stabilization phases. However, suppose investors are looking for a specific type of tenant throughout the rehabilitation period. In that case, they may spend more on advertising (e.g., transitioning from student housing to young professionals).
The operating pro formas will be complete once we add these anticipated costs. Once completed, it will easily calculate the property’s NOI during the rehabilitation stage and after stabilization for investors.
The operating pro forma does not include the price of the renovations. Capitalized expenses like these are included in the taxable basis of a property but not in its operating income. Mortgage interest and depreciation are also not considered operating expenses and should be excluded from any operating pro forma (we will account for these expenses later). Instead, these two costs are “below the line” or included in overall profits but not operational profits.
Multifamily Underwriting Step 3: Identifying the Worth of A Property
After rehabilitation, it can calculate the worth of a property by creating an operating pro forma for a stabilized property. Financiers use the commercial value formula for this purpose:
Property Value = NOI / Capitalization (“Cap”) Rate
The property’s NOI is calculated using the stabilized pro forma, and the cap rate will normally function in market conditions. The capitalization rate (cap rate) is a theoretical rate of return on an investment property purchased with cash. Also, the cap rate indicates the property’s stability; the lower it is, the more so. Investors need to consider both A) the quality of the tenants and B) the local market conditions when calculating a property’s cap rate (analytics firms can provide this insight).
For the sake of argument, assume that the stabilized NOI of an apartment complex is $500,000. Assume now that a similar building’s market cap rate is 5%. Given these assumptions, we can estimate that the building’s post-renovation market value will be $10,000,000 ($500,000 NOI x 5% cap rate = $10,000,000).
Nonetheless, we advise being conservative when estimating property values from a bookkeeping viewpoint. We suggest that if the market cap rate is 5%, it should be at least 6% before any projections are made. The resulting stable value is $8,333,333 ($500,000 net operating income multiplied by a discount rate of 6%). It is a necessary safety net for the transaction. The best-case scenario is for the value to be higher, but investors shouldn’t plan on it.
Multifamily Underwriting Step 4: Return to Continuous Financing Availability
Investors can “back into” their long-term financing plan with this estimated market value. Value-add agreements are common among investors, who often employ short-term finance to buy and improve the property. After things have settled down, they switch to a commercial mortgage with a longer term.
The loan-to-value (LTV) ratio is the standard for these types of mortgages. In other words, lenders will extend credit based on the stabilized property’s worth. Although loan-to-value ratios (LTVs) are subject to change from lender to lender, 75% is often used as a benchmark. To calculate the entire amount of funding, investors can utilize the stable value established in Step 3.
Using the same numbers would suggest that $6,250,000 in permanent financing ($8,333,333 stabilized value * 75% LTV) would be accessible to investors. It tells backers that they can roll over a balance on a short-term purchase or construction loan of up to $6,250,000. It will use this figure in subsequent steps to guide purchase and construction budgets.
Multifamily Underwriting Step 5: Verify Acquisition / Restoration Financing and Budget
In Step 4, investors settle on a permanent financing solution and set a purchase and renovation spending cap based on that number. However, figuring out the exact renovation cost will necessitate working closely with the project’s general contractor (unless the investors are experienced contractors).
Fortunately, most commercial banks provide loans that can be used for both buying a property and building on it. The investors only need to find one source of quick cash flow now. Many financial institutions base their decisions on the loan-to-cost ratio (LTC) instead of the loan-to-value ratio (LTV) when making these loans.
Let’s pretend that the apartment building is now listed for $4,000,000 and that the contractor’s value-add renovation budget is $2,000,000, for a grand total of $6,000,000. This property could get a $4,500,000 acquisition/construction loan provided the short-term lender is willing to provide 75% LTC conditions.
It must examine its acquisition/construction expenses through two different lenses. At the outset, investors will want to be sure that the balance of any temporary loans will be covered by permanent financing. At this point, we knew that the stabilized property could get a long-term mortgage for a prudent amount of $6,250,000. There is a substantial safety net of $1,750,000 for short-term interest payments, normally rolled into the loan balance until a predetermined date ($6,250,000 permanent mortgage minus $4,500,000 short-term loan maximum draw amount).
On the other hand, the amount of supplied capital should be considered while calculating these prices. We have set aside a total of $6,000,000 for the acquisition and renovation costs. However, only $4,500,000 is covered by the available short-term funding. Because of this funding shortfall, investors will need to invest $1.5 million (or find gap financing to cover the difference until the long-term refinance). With a $1,500,000 investment, the investors will own an $8,333,333 apartment complex (assuming they did not go with gap financing).
Multifamily Underwriting Step 6: Project Cash Flows and Investment Standards
Investors are aware of the stabilized pro formas, total contributed capital, and long-term financing debt service amounts at this stage of the underwriting process. The next step is establishing the conditions under which they can walk away from the transaction. When exactly do they plan on selling the property? Investors can use this data to anticipate A) an exit cap rate (which will allow for an estimate of market value at the sale) and B) property cash flows through the exit of the agreement.
Cap rate forecasting services are available from analytics companies; however, we think a conservative estimate is in order. Cash flows are calculated by taking the expected NOIs for the duration of the contract minus the expected debt service (NOTE: depreciation is a cashless expense that only indirectly affects cash flow if a model incorporates taxes).
With this data, underwriters can check to see if the deal is a good financial bet. The internal rate of return (IRR) over the deal’s life is a reliable metric for longer-term value-add deals like this one. Investing is a concept where the initial outflow of cash ($1,500,000) must be discounted to a rate where the present value of future cash inflows matches the initial cash outflow. While this may sound hard, calculating IRR can be done quickly by entering the initial investment, annual cash flow, and eventual sale price (after subtracting the remaining loan balance) into an Excel spreadsheet.
It is the “magic moment,” the point at which investors finally learn whether or not the numbers justify the deal. Let’s assume this investment group uses a 15% rate of return as its minimum acceptable on a ten-year investment. To proceed with the agreement, it must have an internal rate of return (IRR) of 18% over ten years. Alternatively, let’s say the internal rate of return is 12%. For this reason, shareholders can go one of two ways. They have two options: (1) try to reduce the acquisition price to boost their internal rate of return, or (2) back out of the deal altogether.
Bottom Line
Although multifamily underwriting can get intricate in the details, the process as a whole shouldn’t scare off novice investors. To illustrate this, we purposefully picked a simplistic scenario. Underwriting becomes simple if the investors take a systematic, step-by-step approach.
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