Maintaining a Consistent Underwriting Model
Doesn’t everyone say that they have a conservative model when looking at real estate?
While we approach every deal with an eye on the downside, maintaining consistency in our analysis model has proven to be a recipe for success.
Instead of explaining all the reasons, we are conservative with our model, the purpose of this article is to provide insight INTO the model and the consistent items we consider on each deal.
Almost all business plans are built on the ability to increase revenue and reduce expenses. However, most models have a less-than-robust method to model out the stabilization period to get from in-place performance to pro forma. This can make it very difficult to accept assumptions such as reducing vacancy from 14% to 5% in month 1.
We break down the analysis into three buckets. 1) What is the stabilization timeline in terms of months? 2) Using the acquisition vacancy rate (What is it at take-over) 3) Stabilized assumptions.
For example, as a way to measure the progression of the plan, you can take the vacancy rate at acquisition less the stabilized vacancy rate and then divide it by the number of months in the plan. This will give you a monthly checkpoint to measure progression.
Rent growth assumptions also are treated differently pre-stabilization vs. post-stabilization.
Once the property is stabilized, only then is the annual rent growth assumption applied to the rents (this means that we are projecting 0% market rent growth throughout the stabilization period and are relying 100% on the value-add improvements to increase revenue).
After setting aside reserves at the point of acquisition, Our model includes replacement reserves above the line (not as capex) thereby reducing the projected NOI throughout the investment. Not only are these replacement reserves accounted for as operating expenses, but they are also assumed to be fully spent.
Depending on the deal and debt structure, this is very unlikely to occur because value-add deals have a lot of upfront capex work budgeted which reduces the likelihood of large future capital expenditures. Furthermore, it is largely our intention to sell or at least refinance once the value-add business plan is fully completed, thus limiting the risk of unanticipated capex eating into replacement reserves.
This is how we value the property at the exit of the investment. The terminal cap rate is the cap rate used at the time of sale or exit.
There are many ways to calculate your projected sale price. Our exit price is calculated by dividing NOI by a terminal cap rate.
Each year, we assume cap rates will be higher so we increase our basis point accordingly.
How you calculate the NOI used in the terminal valuation can have a significant difference in the valuation assumptions.
We like to leverage the existing or trailing NOI vs. the end of year 1 NOI. This provides a more realistic assumption of operations during year 1. As a result, this may project a slightly lower internal rate of return (IRR) but is more accurate.
These are just a few examples we think about when looking at a multifamily acquisition. There are additional items around debt, taxes, and rent escalations that are important.
Having a consistent model helps accelerate our ability to analyze a deal and make better decisions on where we want to invest our own capital as well as our investors.
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