When screening a potential investment, an underwriting team reviews a substantial amount of data and information in order to determine the financial viability of the opportunity. Naturally, one of the biggest drivers of the economics behind the deal is the potential for future income. But how does one determine what the potential income – and ultimately the value – of a property could be?
As we’ve discussed in our prior articles, the process of underwriting a deal is largely an exercise in formulating financial assumptions and then verifying those assumptions through diligent market research. The income that a property will earn is derived from the rents it can charge tenants. However, one cannot conclusively know what rents they will be able to charge when a large-scale renovation or ground-up development is completed, which can often take 12 to 36 months. Instead, they must rely on experience and market data to formulate and verify rental assumptions. This is achieved by analyzing the rents from market comparables (or “comps”), which are similar competitive properties.
Competitive rents may be obtained through several methods. The most important of these methods is to physically visit and walk through properties in the subject market. Additionally, databases that track this information can be utilized and property leasing offices can be called to verify rents they are charging.
While this may seem like an easy exercise, there is actually a lot of skill required to identify appropriate comps. For example, if a prospective opportunity will be a Class A ground-up development, it’s obvious a Class C property will be irrelevant for rent comparison purposes. But what about a Class A property that is in a great location.
Or take a property separated by a mere half mile from the prospective investment that is otherwise identical. Should it be considered a comparable property? That can depend on its surroundings. A property in a downtown location near public transportation may have significantly higher rents than the exact same building located off the beaten path. Amenities are another factor that can impact rents and whether a property should be considered a comp. A doorman, pool or on-site parking garage can be instrumental in the rental rate.
An experienced sponsor will know how to evaluate different properties and what to include, exclude, or include with relevant adjustments. This aspect of underwriting is crucial as a property’s value is only as strong as its revenue.
Another critical application of reviewing comps is to evaluate whether the purchase price and prospective sales price for a given property is within average market ranges. By using recent sale comps in the target property’s market, one can determine if the property is being purchased at or below market prices, or if the offering price is grossly overvalued. And in order to model a reasonable exit value, which is generally what drives much of the returns in an investment, underwriters need to determine what is the market range for the sales prices.
In this exercise as well, it is imperative that the sponsor select properties that share important similarities while being able to adjust for differences. This too requires experience and a solid understanding of the business plan, including the projected hold period. Ultimately, an investment’s success pivots upon making reasonable and informed assumptions. By choosing relevant properties to build a comparable set to base financial assumptions on, an experienced sponsor can more confidently project what the future potential is for an investment’s income, and accordingly, what the property’s value could be.