Apartment Financial Underwriting - A 2-part Series

[Scott Choppin]

In a few recent conversations with different folks, it has come up how they are calculating financial performance on multi-family projects. And to be honest, I feel the need to generate a specific post on this, since in many of these conversations folks were mixing the financial ratios up between project types. Now, no one's going to die from this mix up, but it does speak to the identity of the person who is speaking the ratios. I am grounded that in all cases, investors, lenders, and land sellers will hold the person speaking in a different regard if they are accurate in their assessments of financial performance of real estate projects.

Generally, in the multi-family development and institutional level value-add markets, we use the following ratios:

NOI/Cost

Internal Rate of Return

Equity Multiple

Cash on Cash Equity Returns (ONLY on stabilized operations cash flow)

In Part 1 of a 2-part article, we'll delineate how to model an apartment project cashflow. Part 2 will delineate the calculation of the ratios.

Proforma Analysis

The basics of a financial model or “proforma” for a development project:

Income and Expense

Construction Period Cash Flow

Internal Rate of Return

Income and Expense Analysis

On apartment deal underwriting or financial analysis, we’ll first break it down very simply for you to gain an understanding of the fundamental components of income and expense analysis for an income producing property. Once you get that, you’ll be able to use it daily and effectively, then make it more complex as you get more seasoned in your underwriting skills. But as you underwrite deals, you will always be able to hold the basic structure in your mind, then work the details on each deal in a spreadsheet that you can easily build yourself.

Basic rental income and expense summary:

Rental Income from all units, also called Gross Income

Less Vacancy Factor (typically 5%)

Equals Gross Adjusted or Effective Gross Income (has various names, but this is what I call it)

Less Operating Expenses and Reserves

Equals Net Operating Income

This fundamental formula applies to all income producing properties, apartments, office, retail, self-storage, etc. Each component may have a different name, or be subject to slightly different allocation of cost (triple net office has the tenant pay most of the operating expenses and property taxes), but the bottom line number that we care about is Net Operating Income or NOI.

When you hear people talk about NOI, you'll know how that is defined (formula above). What it means is the amount of money or cash flow that is available to make the loan payment, and the amount of cash flow that can be used to value the property in a sale or refinance. Using this formula, combined with cap rates (see below), you can underwrite all types of income property investments.

Construction Cash Flow Analysis

This is the flow of expenditures during the construction period. This cash flow schedule is particular to a development project, as you will need to calculate the interest on borrowed funds and the preferred return paid on equity as a function of your construction period expenditures. A normal investment property doesn’t have major expenditures beyond the purchase, whereas a ground up development project has all the necessary expenditures to complete the units and lease them up.

The construction cash flow is nothing more than a spread of each construction cost line item over the specific time period of your construction schedule.

Generally, the time period of construction is derived during your initial due diligence and provided to you by your in-house construction team, or a third party general contractor. A rule of thumb is to always allow more time than you think to build. Unless, you are a production home builder constructing the same unit plan over and over again, a custom or one-off design can only be roughly assessed for total construction schedule. You always need to leave yourself extra time in your schedule. This can be for the normal friction of time loss due to city inspection delays, weather delays, RFI’s, and owner initiated plan changes. On the opposite end of the spectrum, you could assume significantly longer time periods for construction than your team indicates, but this will erode your financial returns due to overly conservative (meaning higher) amounts of interest carry and pref returns on equity. So you need to strike a balance, with some “cushion” to protect against normal friction.

Assessments of Value - Using Capitalization Rates

Once you have the NOI, you can then value the property using the Capitalization Rate or Cap Rate. These are market based assessments of value, that can then be used to underwrite your project. On a development deal (and on all "value add" deals) we have two cap rates:

1. Development cap rate, which is the NOI divided by the cost of the project, or NOI/Cost. When we speak, we say "NOI to Cost". This is what is used when running proformas to determine value at sale or refinance once the project is built out, leased up and producing income (or projecting these values during initial underwriting). This ratios is also used as a comparison tool for the market or what other development projects are producing with which we compete. You might say: "we are building to a 6% NOI/Cost, what are you building to?" or "the equity investor says they want a 7% minimum NOI/Cost, do our numbers meet that criteria?"

When an equity investor is making an assessment of your project, they will ask what is your NOI/Cost ratio (i.e. development cap rate). Example: Our Cedar project is producing somewhere over a 7.5% NOI/Cost. If other developers' project is producing a 7% ratio, our project is producing a superior offer or more NOI to each dollar of cost spent to produce that NOI.

2. Exit cap rate. This is the cap rate in the market upon sale of the project, that determines the value of project upon sale or refinance. This is derived by taking the NOI produced by your project and divide by the going cap rate gained from market research.

Example:

"Broker says that our project should sell at a 4.5% cap rate, our NOI is $100,000, so our value should $2.2M at sale" ($100,000 divided by .045 = $2,222,222).

Another way is that you actually sell at a price derived from a bidding process that you produce in the market, and then divide the sale price by the NOI to get the cap rate at sale: "Our sale price was $8.69M, our NOI was $400k, so our cap rate at sale was 4.6% ($8,690,000 divided by $400,000 = .046 or 4.6% cap rate)

The difference between the development cap rate (NOI/Cost) and the Exit Cap Rate is your development profit. Let's say you can develop to a 7.5% NOI/Cost and sell at a 4.5%. Your spread is 3%, which is the value you've produced as the developer. You may more simply say total sales prices less total project costs is your development profits, but I want you to see where we get the value for the sale or refinance first, then you can use that to subtract and calculate the profit. Of course, the market always dictates, so the more buyers you have bidding for your project the better the price you can demand. We always want to create an auction for our project when able. But the market sometimes goes against you, so you may not get an auction, or worst case, in a down market you may sell at an actual auction. But the main purpose of delineating cap rates here, is to understand the meaning of NOI in the creation and assessment of value for an income producing project.

Remember: when speaking with sophisticated investors, knowledge of these ratios and the ability to work them and speak them, will set you apart from the rest of the market.

Here is a sample proforma:

Proforma 

Construction Cash Flow Analysis

Internal Rate of Return Analysis

[Scott Choppin]

Investment Yield Ratios

In Part 1 of this series, we covered the basic organization and structure of an apartment proforma, income and expense summary, and a construction cash flow schedule.

In this 2nd part, we'll cover investment yield ratios that we utilize as a professional development company, to analyze the return characteristics to determine if a project is worthwhile in our initial underwriting, as well as, provide final financial return reporting on completed projects.

In the development business, these are the major financial ratios used to measure investment yields on equity investment by professional developers, institutional level and mid-size equity investors:

Internal Rate of Return

Equity Multiple

ROI or Cash on Cash

Internal Rate of Return

First, the textbook definition:

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company's required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Now, the real world definition:

IRR is the rate of return produced by investing equity into a development project at the beginning of a project's investment cycle (this could be cash used for predevelopment costs, land close, and funds for construction) and getting repayment of original investment plus yield on the invested capital at the end of the project. The major advantage to using IRR, is that it takes into account the time/value of an investment, and allows IRR or rates of return to be compared between investments with different time cycles. You can compare an equity investment for a project that takes 1 year to invest and repay, to a project that takes 7 years to invest and repay, then choose which produces the higher IRR. This is why IRR is used by sophisticated and institutional level investors.

Understand this: the longer an investment takes time wise, the more likely the total IRR will be lower and trend downward. As well, the opposite is true, if the investment time cycle of a project is very short, the IRR could spike very high, especially when an investment period is under one year.

Once the first dollar of equity is invested then the clock to calculate the IRR starts and ends upon the final repayment of the original equity investment, any preferred return (called "pref") and the backend profit splits allocated to the equity investor. We'll explain more about the practical aspects and presentation of IRR's when we write about raising capital in the equity markets.

One item to remember: IRR is not an assessment of risk, and is an assessment of generated returns on invested equity over a given time period. Although IRR can be used to compare investment choices as stated above, you as the developer must make an assessment of risk and any associated mitigations to risk in order to effectively compare potential investments.

Equity Multiple

First, the textbook definition: A ratio dividing the total net profit plus the maximum amount of equity invested by the maximum amount of equity invested. The Equity Multiple (EM) of an investment does not take into account when the return is made and does not reflect the risk profile of the offering or any other variables potentially affecting the project’s return.

There basic formulaic structure for EM:

Equity multiple = cumulative distributed returns / paid-in equity

or

Equity multiple = paid-in equity+yield on equity / paid-in equity

The way I think of equity multiple pragmatically is this: What's the ratio of the dollars I get back based on dollars I put in? EM is a way to measure the whole dollar return of the project given the investment. Many times an institutional investor or fund wants to achieve a certain amount of dollars back from the investment, say 2 dollars for every dollar invested, or a 2.0 equity multiple. This can help them measure and account for the time, energy, and money they invested. Is it worth investing in, if it does or does not return a certain amount of whole dollars?

As an example: An equity multiple of 1.3 is less attractive to an investor versus 2.0 multiple. EM is a static measurement and does NOT account for the time value of money in the measurement. It just says plainly: How much money do I invest, and how much money do I get back, and what is that ratio?

Example: We invested $50,000 in equity in the project, and received total distributions of $100,000. So our EM is 2.0. But, if the time period for the payout was 18 month the IRR might be 40%, but if paid over 10 years the IRR might be 15%*.

* these examples are simplified for this explanation and are not real measurement of yield.

You really want to use IRR and Equity Multiple in tandem, each to measure yield on the project in different ways. IRR is a dynamic measurement of yield that accounts for the time value of money and total investment returns over time. EM is that ratio or measure of the total magnitude of generated yield in terms of whole dollars.

Cash on Cash (COC) Return or Return on Investment (ROI)

COC/ROI = Yield*/Paid-In Equity

* In this case, yield could be total profits generated from the sale of property, or it could be annualized cash flows from income producing projects.

This is a simplified method of calculating yields on equity investments. It is (or can be) a dynamic measurement of yield if applied to ongoing cash flows generated from net rental income. When applied to a one time capital event, a sale for example, it is a static measurement. Some non-institutional investors use ROI as their preferred measurement, in many cases because calculating IRR is a more complicated calculation. But like EM, it does not take into account net present values of cash flows over time, and therefore is not completely accurate and usable to compare alternative investment choices. For our company, we like to use COC to measure the potential annual net cash flows when underwriting development projects that may be long term hold candidates.