It takes more than good luck and sheer intuition to achieve consistent success in real estate. Experienced sponsors thoroughly examine every aspect of a possible acquisition before making an equity investment. This process — known as “underwriting” — is used by industry experts to assess a property’s return potential and the viability of the sponsor’s proposed business plan. Underwriting lies at the core of all successful real estate transactions and the integrity of this process cannot be overstated.
Screening the Deal
Every sponsor has its own unique investment goals. Therefore, they will look at different variables when purchasing a property. This article focuses on the value-add strategy often employed in multifamily investing, in which a sponsor will typically identify an underperforming, income-producing property that is priced below what a similar stabilized property would sell for in the same market. By performing interior and exterior renovations and implementing more efficient and effective property management, the sponsor can attract new tenants at higher rents. The increased income will allow the sponsor to sell the property at a premium price, thereby adding value to the property (hence the name “value-add”). This all sounds great in theory, but how does the sponsor know the economics of the deal are feasible, the renovation costs are reasonable, it will be possible to fill the building with new tenants at higher rents, or whether the property will sell at a gain?
While no sponsor has a crystal ball, the answer to these questions are all determined during underwriting. Underwriting begins as soon as a sponsor identifies an asset that it seeks to acquire. The first step of underwriting is often referred to as “screening.” The goal of screening is to weed out the mediocre investment opportunities so sponsors are left with deals that exhibit strong fundamentals and deserve deeper analysis.
Screening starts by developing a financial model — also called a pro forma — that spells out the business plan using real numbers. The pro forma depicts how all sources of capital (e.g., equity from investors and loan proceeds from a lender) will be spent, including the acquisition price, construction costs and other fees related to the transaction. Furthermore, it lays out precisely how a sponsor’s business plan is expected to generate income throughout the hold period. It also outlines how the sponsor intends to exit the investment, pay back its investors and distribute profits.
Experienced and disciplined sponsors will turn down many deals before they decide to pursue one. When that diamond in the rough is found, the main phase of underwriting can begin.
Quality, Experience and Assumptions
While financial models are a fundamental tool used to make investment decisions, a model itself is only as good as the quality of data it contains. How reliable is a financial model that uses 5% year-over-year rent growth when the market in which the property is located typically experiences 1% year-over-year rent growth? There are dozens of such inputs — often referred to as “assumptions” — in a financial model. Sponsors rely on market data, historical performance and most importantly, experience. Each market is different, and sometimes, the distance of just one block can drastically impact assumptions. Sponsors must ensure their assumptions are realistic in the subject market.
An important way to formulate proper assumptions is to understand a subject property’s competition. This is achieved by researching the performance of competing properties near the targeted property to understand rents, concessions, occupancy, amenities and the neighborhood. Sponsors will also visit the subject property and its competition in order to understand the market. Additionally, sponsors will analyze the pipeline of new construction that is expected to hit the market during the investment’s hold period. Combined, these integral steps can reveal how much competition a property will face after improvements and whether a sponsor’s post-renovation rents will be perceived as a bargain compared to other apartments in the area.
Underwriting also requires an abundance of fact-checking, which starts by verifying the monthly income or “gross revenue” of a property. This is done by obtaining the property’s rent roll — a list of all tenants, rents paid, concessions, vacant units and unit types (e.g., 1-bedroom/1-bath or 2-bedroom/1-bath). The rental income must be validated by sponsors during the rent roll analysis because it forms the foundation for all of the revenue calculations in the financial model. Experienced sponsors can quickly identify when an asset’s base rents are below market and are ripe for an increase following renovations and operational enhancements.
Sponsors will also review the revenue being generated at the property outside of rents, typically referred to as other income. Other income can be comprised of additional fees charged to tenants, tenant reimbursements for utilities as well as other revenue items such as storage or parking income.
Sponsors must also understand the special deals that landlords offer to potential renters, commonly known as “concessions,” in order to stay competitive in the market. An example of a concession is offering a month of free rent. Sponsors need to include the market’s average concessions in their financial analysis in order to create an accurate model. Concessions are especially important when new construction is hitting the market, because developers often offer heavy concessions to help lease up a new building.
Furthermore, sponsors have to take into account possible vacancies and credit losses, which offset the revenue potential of a property. Vacancy is important because not all units will be fully occupied at all times. Sponsors should understand the specific market of a targeted property to know what vacancy level to use in the financial model. Credit loss is the assumption that not every tenant will pay every penny on time. In order to properly plan for these tenants, sponsors will include a credit loss adjustment to a property’s revenue.
After subtracting concessions, vacancies and credit loss from the gross revenue, sponsors are left with a property’s “effective income.” In underwriting, that is viewed as the actual income a property will earn and it is the dollar amount from which expenses are deducted.
Once sponsors are comfortable with a property’s effective income, it’s time to dive into the property’s operating expenses. They do this by reviewing the current owner’s “trailing 12” (T-12), a document that details the actual historical operations of the property over the prior 12-month period. The T-12 serves several purposes. First, it helps clarify the types of expenses that a property has incurred and can expect in the future. Second, it allows sponsors to identify expenses that are being mismanaged and can be corrected with the implementation of proper management and cost-saving methods. Third, the T-12 helps flush out any operational concerns at the property.
Sponsors will compare the T-12 against their assumptions to ensure that they are not missing any items and that their assumptions are not too aggressive. For example, if a sponsor assumed insurance costs for a property will be $2,500 annually and the T-12 reflects insurance costs of $10,000 annually, the sponsor will have to carefully analyze the discrepancy. Does the current owner overpay for insurance due to inexperience? Or is there an underlying condition at the property that is driving up the costs of insurance? Underwriting is a crucial process that enables the sponsor to learn about the property and obtain answers to these types of questions. The information uncovered during underwriting can drive decisions, such as the price to pay for the property or whether to walk away from the deal.
Property taxes are typically one of the largest expenses and must be thoroughly examined prior to acquisition. Every municipality levies taxes differently. While it is important to know what the current property taxes are, it is equally as important for sponsors to understand what can trigger a property tax reassessment, such as extensive renovations or the sale of the property, because it could result in higher taxes.
The sum of all of a property’s expenses are referred to as the “total expenses.”
Net Operating Income
You have now learned how sponsors calculate a property’s effective income and total expenses. Subtracting the total expenses from the effective income, reveals a property’s “net operating income” (NOI). Sponsors use NOI to discern how much money a property currently earns and how much it could earn if their business plans are successful. NOI is also used by sellers and buyers to agree on a purchase price, and by lenders to determine the size of the loan they are willing to issue. It is important to note, however, that the NOI is not the total amount of dollars that will be distributed to investors. A property’s monthly debt service is paid from the NOI, and often, sponsors or lenders will hold reserves from the NOI in case there is ever a shortage of income to pay expenses.
Financing costs are another important piece of the transaction puzzle that sponsors must underwrite. The loan amount will indicate how much equity is needed to fund a deal. There are many different types of loan products, such as bridge financing (short-term loans often used in value-add projects during the renovation phase and until a property is stabilized) and permanent financing (longer-term loans usually only available to stabilized properties). Every loan type has a different term, prepayment option, payment schedule and interest rate, which may be floating, fixed or a combination of the two. In addition, loans can be interest-only or amortizing, where both principal and interest are paid monthly.
During underwriting, it is important for sponsors to understand what loan types are available for their property and on what terms. It is not helpful for sponsors to underwrite a mortgage at 90% loan-to-value and at an interest rate of 4.5% when the property will only support a loan at 75% loan-to-value with an interest rate of 5%. Sponsors rely on their network of loan professionals to obtain the best terms for their project. After debt service payments are subtracted from the NOI, sponsors are left with “project cash flows.” Depending on the business plan, project cash flows may be reinvested into improving the property or they may be distributed to investors.
Renovations and Improvements
Typically, when acquiring a property for a value-add project, there will be renovation and improvement costs. While these are also expenses, they fall outside the operating expense buckets described above. This is because they are not incurred in the ordinary course of operating a property, but instead, are considered non-reoccurring expenses that warrant their own budgets. Often, renovations and improvements are funded from investor equity and loan proceeds at the time of closing. As previously noted, project cash flows may also be used to fund renovations.
The capital expenditure budget establishes what will be performed during the renovation, including soft costs (e.g., architectural plans and permits) and hard costs (e.g., supplies and labor). This budget will vary from deal to deal depending on how much work is needed, as well as the market as costs of labor and materials vary from market to market. Also, the fit and finishes required to be competitive will vary depending on the property’s market and competitive set. It is crucial for sponsors to budget properly. If renovation costs increase, sponsors and their investors will have to come up with additional money, or cut back on the scope of work, both of which could impact the success of a project. Experienced sponsors often have a cash contingency in place in the event that renovation costs increase.
Exiting the Investment, Return of Capital and Profit
Perhaps the most important aspect of underwriting — or at the very least, the detail that investors care most about — is the potential returns that can be realized from a transaction. The internal rate of return (IRR) and equity multiple are common tools used to decide which investments to make, but the veracity of those numbers is only as strong as the underwriting itself. For accurate IRR and equity multiple calculations, sponsors will have to build a distribution schedule — often referred to as a “waterfall” — into the financial model. The waterfall takes the project cash flows and distributes it between investors and sponsors in accordance to the agreed upon terms. The distribution schedule takes into account the projected hold period of the investment, which is why accurate underwriting and sponsors’ experience is so important.
The waterfall doesn’t only include cash flow from operations, it also includes earnings from the refinancing of a loan or sale of a property. Calculating the price at which a property will sell is challenging, as it is impossible to know exactly what a future purchaser will be willing to pay. Sponsors obtain the best estimate by ensuring they have sound business plans to achieve projected rents and increased NOI by the end of the expected hold period. In order to estimate what the property will sell for at a future date, sponsors typically divide the projected NOI at the time of sale by the capitalization rate or “cap rate.” Cap rates are, in very simple terms, the projected rate of return that a purchaser will earn on their investment over a one-year time horizon if the property was purchased without financing. Cap rates vary widely based on asset types and markets, and are affected by outside economic factors, such as interest rates. In order to determine the appropriate cap rate to utilize in their underwriting, sponsors consider all these factors and research at what cap rates comparable properties in the market have recently sold.
After the final sales price is underwritten, the sponsor then reduces that amount by projected costs of sale as well as the outstanding principal balance of any financing to determine the final distributable proceeds. These proceeds are then run through the distribution waterfall discussed above to determine the final cash flows for the property. Once all cash flows to investors are added up, sponsors can calculate the projected IRR and equity multiple of the transaction and determine if the proposed business plan makes sense.
The ArborCrowd Difference
It is clear that proper underwriting is key to the success of a real estate transaction. However, it is difficult for the average investor to know whether to trust a sponsor’s underwriting. Many sponsors simply lack ample experience, and even worse, there are those that mislead investors with overly aggressive underwriting that results in unattainably high projected IRRs and equity multiples.
ArborCrowd only works with experienced sponsors with proven track records that understand how to properly underwrite a deal. Even then, ArborCrowd does not rely on sponsors’ underwriting when evaluating an investment opportunity. Rather, ArborCrowd performs an independent and comprehensive underwriting of each transaction. During this process, ArborCrowd turns down countless opportunities and only features deals that exhibit strong fundamentals on its investment portal. ArborCrowd’s investors can feel confident that the deals presented have been extensively vetted.