How To Preserve Capital in Multifamily Underwriting

Capital Preservation

Multifamily investment sponsors will underwrite 100s of apartment deals prior to making the decision to purchase a building. The goal of evaluating so many deals is to maximize investor returns and preserve capital by implementing a streamlined underwriting process.

There are many aspects involved with underwriting a large multifamily acquisition such as a financial analysis, physical structure inspections, market analysis, demographic studies, property management, estimating repairs in the units, etc.

In this article we will focus on the financial underwriting component and why they are critical to making sure your capital is preserved during the life of your investment.

Successful underwriting includes a systematic evaluation of the proposed multifamily investment to determine the viability and make a determination as to if the property’s actual returns fall within the range for the investor.

The key is that we successfully underwrite the deal by establishing investment criteria beforehand that drive the decision to purchase a property or not.

It’s important to note that there are usually two parties underwriting a real estate deal. Both the lender and the sponsor will have their own independent underwriting criteria which means that there are two independent sets of eyes evaluating the property to make sure that the investors are protected and that the lender feels safe lending money to the sponsor.

Here are the main factors to evaluate when underwriting a multifamily investment.

Cash Flow Analysis

It’s critical that we know what the rental income (rent roll) and expenses are for the building. Oftentimes the information we are given by the Seller will be based on the best case scenario (i.e. high rents, low vacancies and low operating expenses).

What we do when underwriting a deal is request the actual rent roll for the past 12 months. This is referred to as the Trailing 12 or T12. Any evaluation of the income and expenses that is not from the T12 is worthless as it is based on the building being highly occupied with very low operating expenses.

We want to evaluate the deal based on what the current owner has been running the operations at over the past 12 months, not a best care scenario (Proforma).

Components of the income and expenses that we will want to underwrite:

Rents received - What was the actual amount of gross rental income received over the past 12 months.

Vacancy - Estimate a vacancy loss factor in your analysis. Rarely will the units be 100% occupied. We are conservative and use a 5-8% vacancy factor in most scenarios.

Operating expenses - When we take a look at the operating expenses over the past 12 months we will likely see that there are opportunities to increase the cash flow by reducing operating expenses.

Next we will want to begin to evaluate the returns. The main criteria to calculate when evaluating the returns are the annual debt service, the Net Operating Income (NOI) and cash flow.

Let’s walk through each step of evaluating your cash on cash return.

NOI

We calculate the net operating income by subtracting the operating expenses from the gross income for the property. For example, if a property generates $300,000 annually in gross income and $144,000 in operating expenses then your net operating income would be $156,000.

Debt Service

Next, we calculate the annual debt service (principal and interest) based on the loan amount, interest rate, amortization period and down payment we have been approved for by our lender. NOTE: Excel has excellent formulas for these but we typically obtain these from the lenders during the initial underwriting process.

Cash Flow

After we have determined the NOI and the debt service than we will be able to determine the amount of money left over from the investment. This is considered the cash flow for the property and this will allow us to determine the cash on cash return.

In order to calculate the cash flow you simply deduct the debt service from the net operating income.

CoC - Cash on Cash Return

This is where it starts to get fun because we start to evaluate the potential cash on cash return our investors will receive from this investment based on the proposed deal points.

In order to calculate the cash on cash return we want to use this formula: 

Cash on Cash Return = Cash Flow / Initial Equity Investment

For example, if a $30 million apartment building requires a $9 million initial equity investment and the property cash flow is $1.1 million annually then the cash on cash return would be 12%.

Evaluation of the cash on cash return is what most sponsors will underwrite to determine if it makes sense to do further analysis. If the cash on cash return is not adequate based on the deal terms then there is no need to proceed with evaluating other financial ratios.

Once the sponsor has determined what the purchase price needs to be based on an acceptable cash on cash return and feels like there is reason to continue the analysis they will begin to evaluate more sophisticated financial ratios like the internal rate of return and debt service coverage ratio.

Internal Rate of Return – IRR

The internal rate of return (IRR) is a method of calculating rate of return which as the name implies does not involve any external factors, such as inflation, cost of capital, deal structures, market conditions, etc.

Often time’s sponsors will use the IRR to evaluate if it makes more sense to purchase an existing apartment building and renovate it, purchase a newer building with minimal improvements needed or build a brand new apartment building from the ground up.

Debt Service Coverage Ratio - DSCR

Debt service coverage evaluation of cash flow, after income and expenses, available to the sponsor to pay the annual debt service. The DSCR could be used in a scenario where the sponsor is wanting to to determine the their ability to repay annual debt service based on the annual cash flow produced by the property.

For example, if the annual debt service on a building is $300,000 and the property NOI is $420,000 then the DSCR is 1.4 which means the property produces 40% more income than is needed to pay the debt service.

You can also use the cap rate calculation to compare multiple investments against each other.

To evaluate the value of an apartment building you would divide the NOI by the cap rate:

Value = NOI / Cap Rate

After the we have determined what the cash on cash return is then we will want to determine what the market cap rate is for similar type buildings in this area. Using the NOI and the market cap rate we can get a benchmark for the value of the building and how that compares to what we would be comfortable paying for the property.

To evaluate multiple properties we would divide the purchase price by the NOI of each building to get a cap rate.

A rule of thumb is the higher the cap rate is the lower the purchase price is. Often times if a sponsor is evaluating multiple deals simultaneously we will take a stronger look at the higher cap rate deals. This is not to say that a deal with a lower cap rate is a bad deal or it’s overpriced it may be more stabilized then the higher cap rate properties. NOTE: Be careful not to pigeonhole yourself into thinking that a higher price means a worse deal.

Once we have these calculations established we can test tolerances by changing assumptions to determine how the changes affect the cash flows, ratios and returns.

It’s critical that you invest with sponsors who are able to look at and underwrite many deals. This is to ensure that your sponsor has experience acquiring large multifamily properties so you can feel more comfortable knowing that your capital will be preserved in an income producing investing.