Multifamily Real Estate Underwriting Masterclass

What is Underwriting?

Underwriting is the analysis of a potential real estate acquisition using past and current performance to determine if the deal will meet the return expectations of the buyers.

Underwriting is Where the Process Begins:

• What is underwriting?

• Why you must underwrite?

• OM, Rent Roll, T-12

• Compare subject property to comps

• Compare past, current, and future numbers

• Introduce case study ($10M)

The Offering Memorandum

Offering Memorandum from the Broker

The Basics from the OM

• Name and address of the property

• Year of construction

• Number of units and total square feet

• Unit mix breakdown

• Number of buildings and site map

• Property summary and description

• On site amenities and updates

• Jobs market

• Demographics and submarket

• City highlights and landmarks

Diving Deep into the OM

Analyzing the OM

• Location description and local map

• Demographics, jobs, nearby retail

• Photos, floorplans, site map

• Proforma income

• Snapshot of rent roll

• Performance of local comps

Rent Roll Information

Understanding How to Use the Rent Roll

• Unit number by first and last name of tenant

• Includes floor plan and square feet

• Denotes each unit as occupied or vacant

• Lease start date and end date for each unit

• Market rent, additional (rehab) rent, leased rent, effective rent

• Pet fees, late fees, deposit, month to month fees, concessions for each unit

T-12 Data

Understanding the Trailing 12

The Importance of the T-12

• Lessons 7 & 8 in this course will dive deep into calculating from the T-12

• Gross potential income, income loss, other income, net income

• Expenses: Taxes, insurance, managing, servicing, utilities, and logistics

• Net Operating Income = Total Income – Total Expenses

• NOI is a vital determining factor when purchasing a property

• Debt Service and CapEx are “below the line”

Know How to Calculate

• NOI=Purchase Price x Cap Rate

• Purchase Price = NOI / (Cap Rate)

Basic Deal Metrics

Per Unit Price = (Purchase Price) / (Number of Units)

Downpayment = Purchase Price x (20% to 30%)

Leverage = (Loan Amount) / (Purchase Price)

First, find out the leverage the bank will give you then you can calculate the down payment required. This is typically as a percentage (price changes).

Total Raise

= Total Downpayment + Repairs & Reserves + Closing Costs+Any Fees (ie. Acquisition Fee)

Basic Deal Closing Costs

Closing costs (2-3%) = Lender/3rd Party + Title + Reserves + Travel

Title/Legal = Title Search + Title Policy + Title Processing Fee + Survey + Recording + Transfer Taxes + Attorney Fee (LLC & PPM)

Lender/Third Party = Property Inspection + Lender Fees + Appraisal + Bank Doc Prep Fee + Origination Fee

Reserves

= Lender required reserves + Real estate taxes (6 months) + Insurance (6 months)

Target Rent Analysis

• Detailed breakdown from OM of all units

• Floor plans, # of beds/baths, square footage, total units, market rent, effective rent.

• Market, Effective, and Target Rent

• Market Rent is what the leasing office will list as full market rent (street rent)

• Effective Rent is what the tenant actually pays

• Your Target Rent is where you would like to push the rent as you update/renovate the units

• Occupancy goals need to be balanced with rent increase

• Rent increases are gradual and seen when units are vacated and then updated during turnover

• Full target rent across the entire property usually takes 1-3 years to achieve

How to Calculate Target Rent

Calculating the Target Rent

1. Build a table of all floor plans separated by # of beds and sorted by sq. ft.

2. For each floor plan find the price per square foot

3. Price per square foot = (Market Rent)/(Square Feet)

4. Repeat this calculation for the effective rent

5. Along with your own market research, work with your property management company to determine what target rents are realistic to achieve

6. Use this to determine how far you can push target rents, and build a table

7. Any renovation or rehab can also help achieve higher target rents

Gross Potential Income

• Gross Potential Income(Rent) = Average Market Rent x Total # of Units

• There are several items subtracted from the gross potential income such as vacancy, concessions, loss to lease, bad debt, etc.

• Vacancy = (# of Units Not Occupied) / (Total # of Units) x 100%

• Concessions = All price considerations/reductions

Used commonly for customer service, persuasion, seen as move in specials such as 2 months free incentive

• Loss to Lease = Market Rent – Effective Rent

• Bad Debt = Uncollected rent from tenant neglecting/refusing to pay

Other Income and Total Net Income

Other Income

• There are also items that are added to the gross potential income such as laundry, vending machines, storage units, parking, late fees, pet fees, utility reimbursement, etc.

• These are important sources of “other income”

Total Net Income

• Total Net Income = Gross Potential Income – Vacancy – Concessions – Loss to Lease – Bad Debt + Other Income

• Total Net Income is the actual amount of income the property can use at its discretion and is a vital metric to calculate

Property Expenses

Calculating the Property Expenses

Variable Expenses

• Payroll = $185,000

• Turnover Expense = $63,000

• Repairs and Maintenance = $56,000

• Management Fee = $45,000

• Water and Sewer = $72,000

• Electric = $29,000

• Gas = $20,000

• Marketing = $19,000

• General/Admin (G&A) = $18,000

• Miscellaneous Expenses = X

Fixed Expenses

• Real Estate Taxes = $208,000

• Property Insurance = $ 71,000

• Contract Services = $61,800 (Trash, Pest, Landscaping, etc.)

• Deposit to Replacement Reserves = $42,000

Net Operating Income (NOI)

The Vital Lifeblood of the Deal

• Using Lessons 3 & 4, we will calculate the Net Operating Income (NOI)

• Net Operating Income=Total Net Income-Total Expenses

• This includes all expenses except for debt service and capex

• Rent and expense escalators

• Important evaluation of the property

Relation to Price and the Cap Rate

• NOI = Purchase Price x Cap Rate

• Purchase Price = NOI/(Cap Rate)

Debt Service (Mortgage Payment)

What is Debt Service?

Crucial Numbers to Manage

• Total Loan Amount

• Amortization

• Annual Debt Service & Monthly Payment

• Interest Rate Percentage

• Length of Loan (in Years)

• Any IO? (Interest Only)

How Type of Debt on a Deal Affects DSCR

• Agency

• Bridge

• HUD

Debt Service Coverage Ratio (DSCR) = (Net Operating Income)/(Annual Debt Service)

The Buzz Words and Returns

Important Metrics and Returns

• Cashflow

• Cap Rate

• Reversion cap rate

• Total Return

• Cash on Cash Return (COC)

• Average Annual Return (AAR)

• Internal Rate of Return (IRR)

Deal Structure and Return Impacts

Benefits of a Preferred Return

What is a preferred return?

• Typically, 4-8% preferred return

• Between 60/40 and 80/20 split beyond the preferred return

With Preferred Return vs Without

• Preferred return ensures the first pre-determined percentage of distributions are returned to investor before sponsor

• After the preferred return percentage, some sponsors may take a pre-determined split, or they return the remaining cashflows to the investors as return of capital.

Benefits of a Waterfall

Waterfall with IRR Thresholds

• 90/10 until 10% IRR threshold

• 80/20 between 10% and 15% IRR threshold

• 60/40 above 15% IRR threshold

Waterfall Structure Benefits

• This highly incentivizes the sponsor to perform

• When the sponsor forces the property to achieve extremely high IRR returns, then the sponsor receives splits well in his/her favor

• This builds higher confidence in the investors that the sponsor believes the property will perform