For many new real estate investors, underwriting – or analyzing – a potential deal remains a major mystery. People hear the term “underwriting” and assume it’s some extremely complicated process. While some deals are more complicated than others, the process of underwriting a multifamily property deal proves fairly straightforward. Simply put, underwriting means running a deal’s numbers to confirm that they support investment objectives.
In this article, we’ll outline a step-by-step approach to underwriting and analyzing a multifamily property deal. Specifically, we’ll cover the following topics:
- Overview and Assumptions
- Multifamily Underwriting Step 1: Confirm Rents
- Multifamily Underwriting Step 2: Confirm Operating Expenses
- Multifamily Underwriting Step 3: Determine Property Value
- Multifamily Underwriting Step 4: Back Into Permanent Financing Availability
- Multifamily Underwriting Step 5: Confirm Acquisition/Rehab Budget and Financing
- Multifamily Underwriting Step 6: Project Cash Flows and Measure Investment Criteria
- Final Thoughts
Overview and Assumptions
As stated, the general objective of deal underwriting remains the same, regardless of the type of deal. That is, investors analyze a potential deal to see if its return will support their investment objectives.
However, the specifics of the underwriting process vary by deal type. For instance, developing a property from the ground up will have different considerations than purchasing a stabilized apartment building. Similarly, incorporating historic tax credit investors or other unconventional equity partners can complicate matters.
Accordingly, we will use this article to provide the basic steps to underwriting a multifamily property deal. More precisely, we will discuss the underwriting for the A) purchase, B) value-add rehab, C) subsequent stabilization, and D) ultimate resale of a multifamily apartment building. As such, we assume that this property currently has residents, necessitating a staggered rehab of each unit.
Multifamily Underwriting Step 1: Confirm Rents
When underwriting a multifamily property, investors need to first project operating results. Known as pro formas, these projected operating results allow investors to make certain operating assumptions to estimate future results. And, we recommend beginning with the top-line results – rents.
To gather information about rents, investors should first confirm the details of each unit (e.g. square footage, current rent, current lease terms, historic vacancy etc.). Next, investors must project a value-add premium to these rents. For instance, after completing the renovation of each unit, a building may command 20% higher rents. And, for investors who need to stagger their renovations over time, this means they need to project rents from purchase through rehab completion. This entails gradually increasing rents – unit by unit – from the current rates to the post-rehab rates. And, the pro formas should reflect both this gradual increase and the eventual stabilized results.
Multifamily Underwriting Step 2: Confirm Operating Expenses
After projecting rent results through the rehab to the stabilized period, investors must then add the projected operating expenses to their pro formas. Once again, looking at historic results can provide key insight here. For instance, reviewing electricity consumption for the past three years should allow fairly accurate projections of future electricity trends.
While operating expense types vary by property, some common ones exist across all multifamily buildings. For instance, most apartments need to account for the following expenses:
- Property management fees
- Accounting fees
- Marketing fees
- Property taxes
- Insurance
- Utilities
- Maintenance
Most of these expenses will remain the same during both the rehab and stabilized periods. However, investors may find themselves spending more on marketing during a rehab period if they seek a different sort of tenant (e.g. transitioning from student housing to young professionals).
These projected expenses will complete the operating pro formas. Once built, investors will have a clear picture of their net operating income (NOI) both during the rehab period and for the stabilized property.
NOTE: Rehab costs are not accounted for in an operating pro forma. These constitute capitalized costs that go into the property’s taxable basis – not its operating results. Additionally, mortgage interest and depreciation do not qualify as operating expenses, so they should not be included in an operating pro forma (we will account for these expenses later). Rather, these two expenses fall “beneath the line” – part of net income but not net operating income.
Multifamily Underwriting Step 3: Determine Property Value
Once you’ve built the stabilized property operating pro forma, you can determine the property’s post-rehab value. To do this, investors use the commercial value formula:
Property Value = NOI / Capitalization (“Cap”) Rate
The stabilized pro forma provides the property’s NOI, and the cap rate will typically be market dependent. Conceptually, cap rate represents a property’s returns on an all-cash deal. And, generally speaking, the lower the cap rate, the more stable the property. To determine a property’s cap rate, investors will need to look to A) the quality of the tenants, and B) the local market conditions (analytics firms can provide this insight).
Say, for example, an apartment building has a stabilized NOI of $500,000. Now, assume the market cap rate for a comparable building is 5%. This means that the projected after-rehab market value of the building would be $10,000,000 ($500,000 NOI / 5% cap rate).
However, from an accounting perspective, we recommend taking a conservative approach to estimating property values. If the market cap rate is 5%, we argue for using at least a percentage point higher to project value. In this case, that would mean a stabilized value of $8,333,333 ($500,000 NOI / 6% cap rate). This provides a critical buffer in the deal. If the final value comes in higher, great, but investors shouldn’t count on a best case scenario.
Multifamily Underwriting Step 4: Back Into Permanent Financing Availability
With this projected market value, investors can “back into” their permanent financing scenario. For value-add deals like this, investors frequently use short-term financing to purchase and renovate a property. Then, once stabilized, they refinance into a long-term commercial mortgage.
These mortgages typically work on a loan-to-value (LTV) basis. That is, lenders will provide a loan based on the value of the stabilized property. While LTV varies by lender, 75% LTV serves as a common benchmark. As a result, investors can now use the stabilized value from Step 3 to determine the total financing available.
Continuing the above example, this means that investors could anticipate available permanent financing of $6,250,000 ($8,333,333 stabilized value * 75% LTV). In simple terms, this tells investors that they can refinance a short-term acquisition/construction loan balance up to $6,250,000. We will use this number to inform the acquisition and construction budgets in the next step.
Multifamily Underwriting Step 5: Confirm Acquisition/Rehab Budget and Financing
With the permanent financing determined in Step 4, investors establish an upper limit to their acquisition and rehab budgets. But, actually determining the rehab budget requires close coordination with a general contractor (unless the investors themselves are experienced contractors).
Fortunately, most commercial lenders offer combined acquisition/construction loans. This means that investors only need to look for a single short-term financing solution. And, for these sorts of loans, many lenders use a loan-to-cost (LTC) – as opposed to loan-to-value – basis.
For instance, say that the apartment building has a current list price of $4,000,000 and the contractor calls for a value-add rehab budget of $2,000,000 for $6,000,000 total. If the short-term lender offers 75% LTC terms, that means this property would qualify for a $4,500,000 acquisition/construction loan.
These acquisition/construction costs need to be viewed through two lenses. First, investors will want to confirm that their permanent financing will pay off their short-term loan balance. In Step 4, we determined that the stabilized property would conservatively qualify for a $6,250,000 long-term mortgage. This provides a significant, $1,750,000 buffer for short-term interest payments, which typically roll into the loan balance until a predetermined date ($6,250,000 permanent mortgage – $4,500,000 short-term loan maximum draw amount).
But, these costs also need to be viewed through the contributed capital lens. As stated, the total purchase and rehab budget totals $6,000,000. But, the short-term financing only covers $4,500,000 of that. This gap means investors must contribute $1,500,000 of capital to make the deal work (or find gap financing to cover the difference until the long-term refinance). If they can raise this cash, the investors will ultimately control an $8,333,333 apartment building for a $1,500,000 capital contribution (assuming they did not go with gap financing).
Multifamily Underwriting Step 6: Project Cash Flows and Measure Investment Criteria
By this point in the underwriting process, investors know the property’s stabilized pro formas, total contributed capital, and long-term financing debt service amounts. Next, they need to determine the deal’s exit criteria. In other words, when will they sell the property? With this information, investors can project A) an exit cap rate (which will allow for an estimate of market value at sale), and B) property cash flows through the deal exit.
Once again, analytics firms can help you project future cap rates, but we argue for a conservative estimate. To determine cash flows, investors simply need to deduct debt service from projected NOIs for the lifetime of the deal (NOTE: depreciation is a cashless expense that only indirectly affects cash flow if a model incorporates taxes).
Armed with this information, the final step to the underwriting process is determining whether the numbers meet the deal’s investment criteria. For longer-term value-add deals like this example, the internal rate of return, or IRR, over the life of the deal serves as a solid metric. Conceptually, investors need to determine the discount rate where the present value of future cash inflows equals the initial cash outflow ($1,500,000). While this may seem complicated, plugging these initial costs, annual cash results, and the final year sale price (net of outstanding loan balance) into an Excel spreadsheet will quickly solve for IRR.
This the “magic moment” when investors find out whether the deal’s numbers support their investment criteria. For instance, say this investment team has a hurdle rate of 15% for a ten-year deal. If the ten-year IRR comes out to 18%, the deal passes muster and should be pursued. Conversely, assume the IRR comes out to 12%. This leaves investors one of two options. They can either 1) negotiate a lower acquisition price to increase their IRR, or 2) walk away from the deal.
Final Thoughts on Multifamily Investment Analysis and Underwriting
While the details of multifamily underwriting can become complicated, the process itself should not overwhelm new investors. We intentionally used a simplified example to demonstrate this point. But, as long as investors break it down into a step-by-step approach, underwriting proves straightforward.
If you’d like to discuss different multifamily investment options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available investment opportunities.