Red Flags to lookout for when Underwriting multifamily properties?
Making appropriate underwriting assumptions before a property is acquired can be highly fraught. There is a multitude of variable factors which need to be taken into account, both macro and micro, when assessing the feasibility of a project—whether it can meet the stakeholder’s target returns, if the projections prove to be too optimistic or conservative, and if it a sound underwriting proposition.
Investment return projections are primarily sensitive to rental growth and exit cap rate assumptions, but other factors (some external and uncontrollable) do come into play. And then, even seemingly minor or relatively insignificant changes to these dual metrics can cause drastic differences to the expected returns and the success or otherwise of the project. Anyone preparing a study and/or sensitivity analysis needs to provide strong justification and qualification for the assumptions they incorporate into their projections.
This said, even the most experienced analysts and real estate investors don’t always get it right, so where are some areas where red flags should be looked for and noticed?
Overestimating current market rental rates
As even small changes in rental levels can have large implications on an investment’s projected return, it’s essential that a detailed market survey of the property’s competitive set be undertaken to determine appropriate rents for the feasibility study. Investors can do this themselves through their own research or by using a third party specialist to obtain their objective opinions.
As part of this survey, current vacancy and rental rates plus factors which, in the short- or medium term, may affect rental demand and direct competitive supply of new properties—and should be taken into consideration. It’s also important to be able to compare like with like and find out what, if any, incentives are being offered by landlords to maintain a high “face rent” i.e. are there any rent free periods at the beginning of or mid-lease or tenant fitting out incentive included in the reported rents?
Rental growth
Once a base rent has been established, it is common to assume that rents will grow in a straight line over time, year after year—even though in the real world, this is unlikely to be reality, due to natural market cycles or some unforeseen event.
Clearly, different markets will not experience the same levels of rent growth, but the majority of sponsors set default rental growth rates at 3% per year. The main rationale is that this has been the average long-term rent growth rate historically. If a sponsor adopts a higher rate than this, it needs to be well justified. Taking the foregoing into account, coupled with the results of the detailed survey mentioned above, such periods of static or declining rentals must be considered when creating the pro forma.
In situations where buildings are acquired to renovate, refurbish and reposition (“add-value”) underwriters can easily become overly optimistic about post-renovation market rents. Again, therefore, it’s important that these estimates of rental be determined by a data-based comparison of the target property to the competitive set in the surrounding area. Consideration of finishes, fittings, amenities, unit sizes, layouts and parking capacity are all examples of factors which can determine whether the newly renovated property is likely to achieve the projected market rents.
Not reviewing the lease schedule or rent roll in sufficient detail
When evaluating any income-producing property for the first time, it’s important to study the rent roll. More so, perhaps for multi-family properties, given that the vast majority of leases will be for 12 months.
Most analysts will focus on the current rent because this drives the property’s income stream. A property’s rent roll provides important information about the tenants who occupy the property at the time of sale, how long they have been leasing, when they moved in and any changes in the rent they pay. Yet a major detail is lease expiration dates and the ratio of expiries in any one month.
When leases expire, the tenant will either renew their lease or not. If not, the investor via its manager must endeavor to find a new occupant. There may be some minor repairs or touch-up works involved as well, plus perhaps leasing agent’s fees. Re-letting takes time (and money), meaning lost income for the property during the vacant period (“voids”) because there is no tenant making rental payments.
Not reviewing lease expirations in enough detail can lead to issues and greater risk, especially if a large number of leases potentially expire at the same time. If, for example, a property has 100 multi-family units, with leases for 20 expiring, this is 20% of the inventory. If tenants cannot be replaced quickly, the property may experience a significant income reduction which, in a worst case, could lead to a liquidity crunch for the owner, especially if there are loans to be repaid.
Under assessing Operating Expenses
The first step in any analysis may be to review the income generated by a multi-family property, the costs of actually running the building have to be carefully scrutinized.
The result of a property’s income less its expenses is usually known as Net Operating Income (“NOI”), and is an important metric that forms the basis for the property’s valuation. This can be found on the properties operating statement and is commonly the last line item.
It is not enough to simply “estimate” operating expenses (items such as taxes, property management, utilities, routine repairs and maintenance etc.) without looking at the property’s past performance over the preceding 2 or 3 years for reference. Changes in occupancy or charges levied by the providers of the utilities will, obviously, have an impact on the overall building expenses.
One of the most common faults is underestimating property taxes. When a property is sold, the value of the property is reassessed, and, especially if the previous owner had held the property for many years, there will be a big jump in the assessed value. Usually, the property’s newly assessed value will equal the sales price so this will form the basis to estimate post-sale taxes and a pro forma needs to take this into account.
Underestimating repair and renovation expenses
Where a value-add strategy is being adopted to acquire, renovate and either re-tenant or resell a property, being able to meet the target investment returns is highly dependent upon accurately estimating not only the costs to renovate but the time involved in such works.
It is very common to underestimate both cost and time and prolonged periods of construction or redevelopment and subsequent lease-up can drastically change investment returns.
There are, obviously, costs to hold the property when the cash flow is not positive (revenues are not sufficient enough to cover expenses) and such “carrying costs” must be funded as capital contributions as they usually relate to interest payments and operating expenses. If the renovation or reletting period is extended, investors may be asked for additional capital contributions and to grant more time before receiving a current yield on their investment.
It, therefore, is important at an early stage to engage with an experienced contractor to develop renovation cost estimates, as well as budget for a suitable contingency which can be used in the event of cost overruns. Wherever possible, a guaranteed maximum price (“GMP”) contract should be negotiated with the contractor, as well as financial penalties if the project is unreasonably delayed.
The contingency line item is usually 10% of the renovation budget.
Not stress testing the pro forma
A pro forma contains an estimate of future income and expenses over a 5 or 10 year period and reflects changes in forecast occupancy levels and the incidence of any major future repairs and so on. Being a forecast, there is, obviously, no guarantee that the actual performance will match pro forma estimates.
Some of the line items are unlikely to vary much from estimates, but others may show a marked change. Therefore, to try and cover some of the possibilities it is best practice to “stress test” the pro forma or do a so-called “sensitivity analysis”. This involves testing certain pro forma assumptions as a means of considering multiple outcomes.
For example, if the pro forma assumes an annual 5% property vacancy rate, the impact on investment returns if this becomes 7%, or even 10%, can be examined. Similarly, if rents go up 5% per annum and not 3%, or closing costs turn out to be 6% and not 3%, what will be the impact?
It is well worth creating a summary ("sensitivity") table showing some of the key variables and their impact on investment returns for an instant visual appreciation of any material changes.
This is a necessity as, in multi-family real estate investing, a common theme is that investors tend to take an overly optimistic view as to the potential performance of a property. It is far better to take a data-driven approach to underwriting multifamily properties and to consider a range of possible outcomes before committing to a transaction.
Purchasing at or above replacement cost
Buying a property above replacement cost is synonymous with overpaying, especially in situations where developers can build a new property to the same specifications at a similar cost or more cheaply.
Therefore, when acquiring an existing property, understanding the cost of replacement is particularly important if the property is located in areas with greater land availability, but less so where vacant land is scarce. There must be sufficient demand to absorb new supply and maintain occupancy and rental rates in less desirable areas.
Final Debt Terms
Typically, the sponsor will not have the finalized debt terms by the time an offering is first presented and investors need to understand what debt terms the sponsor anticipates and how the sponsor formed and can justify their assumptions.
Exit Cap Rates
The expectation when investing in multifamily properties is that the projected cap rate on sale or disposal (“exit cap rate”) should be greater than the purchase price cap rate (“going-in” cap rate).
It is common practice for sophisticated sponsors to underwrite cap rate expansion and the industry standard is to adjust the said rate by approximately 5bps (.05%) per year to account for any uncertainty or variables.
Uncertainty can account for the diminishing desirability of a property type or the real estate asset class as a whole. Future capital expenditure which has not been accounted for in the pro forma, an aging property, rising interest rates, unexpected economic trends, shifts in market or in locational fundamentals, etc all create uncertainty.
The practice of cap rate expansion does not necessarily correspond to historic trends and sponsors are becoming increasingly more creative when underwriting exit cap rates.
Accordingly, investors need to carefully examine the relationship between the going-in cap rate and the underwritten exit cap rate. If there is no cap rate expansion or the exit cap rate is compressed for any reason, investors should carefully review as the lack of cap rate expansion is a major driver of the investment returns presented.
When it comes to underwriting multifamily properties, There’s more to it than just the numbers.
The underwriting process or feasibility analysis is a major part of assessing the attractiveness of a multi-family asset and determining whether it can meet the required investment returns. However, the physical property is also important and it’s necessary to look in detail “behind the numbers.”
Factors to consider include:
Location
Is the business plan justifiable for the location of the property?
What are the positives and the negatives of the location (such as pollution or crime)?
Is the area growing with possible changing demographics or new infrastructure projects?
Are there sufficient amenities such as grocery and other stores, parks, good schools, public transportation nearby?
Are there other private or institutional investors in the area, and so on?
Intrinsic Value
What was the occupancy of the property upon acquisition and what are the tenant demand originators?
Have these changed since the last owner bought the property, and when was this acquisition?
Why did the previous owner sell?
In which areas does the potential for improvement of this property lie?
How did the sponsor acquire this property and what were the seller’s circumstances?
Functionality
Is the property fit for its intended use and does it function well in terms of people flows, vehicle flows and the usability of the units?
Does it have similar facilities, such as parking, outdoor space, elevators, ceiling height, open views, recreational facilities and so on, as properties in its competitive set?
For multi-family properties, do the units have, for example, good living space, in-unit washer/dryers, sufficient bedroom-to-bathroom ratio?
Is the unit mix i.e. 1-bed and 2-bed and maybe some 3-bed units, attractive enough for a good cross section of targeted renters?
Capital calls/additional investment
Capital calls may be planned or unplanned and occur in times of distress and/or to make improvements to maintain the competitiveness of a property. They occur when a sponsor or manager calls on the LP investors to contribute capital for a planned capital expense or to further enhance the property or, maybe, for an unexpected situation in an ongoing investment.
If an investor does not wish to contribute capital at the time it is called, the investor’s interest may be diluted. Alternatively, the sponsor or other LPs may choose to “lend” the capital to the partnership and charge interest on that capital. This gives such party precedence in the order of distributions.
Sponsor
Finally, the sponsor, who may be the most important entity in any investment. The sponsor is responsible for underwriting the deal, presenting the offering, deploying the capital, and executing the business plan.
Some good questions to ask yourself about the sponsor include:
Does the sponsor have appropriate experience in the market and in the product type?
Do they have a track record of executing similar investments and of what nature, i.e. core-plus acquisition, value-add renovation, development etc.?
Are all interests such as sponsor’s fees, incentive structure, position clearly set out and aligned in the capital stack?
Does the sponsor have the resources to execute the business plan, and is there any pending litigation against the sponsor or any relevant information available about their experience and background.
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