For many new real estate investors the question of “How to analyze multifamily investment opportunities” may seem intimidating and complex . However the process of underwriting a multifamily property deal can be more straightforward than one might think . At its core it involves analyzing a deal’s numbers to determine if it aligns with investment objectives . In this article we will explain the underwriting process and provide a step-by-step guide to underwriting a multifamily property deal . Whether it involves purchasing a property, undertaking value-add renovations, stabilizing the property or planning for a future resale we will cover the essential characteristics of underwriting .
Step 1: Projections and Assumptions
The first step in underwriting a multifamily property deal is to project the property’s operating results . These projections which are also known as pro formas allow investors to make assumptions and estimate future financial outcomes . Starting with the top-line results, investors should gather information about rents by examining factors such as square footage, current rent, lease terms and historical vacancy rates . Investors can then project value-added premiums to these rents based on planned renovations . If renovations will be varied over time pro formas should account for gradual increases in rents until the property reaches stabilized occupancy .
Step 2: Accounting for Expenses
After projecting rent results investors must incorporate projected operating expenses into their pro formas . Reviewing historical expense data provides valuable insights for estimating future costs . Common expenses for multifamily properties include property management fees, accounting fees, marketing fees, property taxes, insurance, utilities and maintenance . While most expenses remain consistent throughout the rehab and stabilization periods certain costs like marketing may increase during renovations if the target tenant demographic changes . These projected expenses contribute to determining the property’s net operating income (NOI) during both the rehab and stabilized phases .
Step 3: Property Valuation
Once the stabilized property’s pro forma is complete investors can determine the property’s post-rehab value . The value is calculated using the commercial value formula:
Property Value = NOI / Capitalization (“Cap”) Rate .
The NOI is obtained from the stabilized pro forma and the cap rate is typically market dependent . A lower cap rate indicates a more stable property . By considering tenant quality and local market conditions investors can determine an appropriate cap rate for the property . Applying the cap rate to the projected NOI yields an estimated market value after the completion of renovations .
It is sensible to take a conservative approach when estimating property values and use a slightly higher cap rate than the market average . This approach provides a safeguard in case the final value falls short of expectations .
Step 4: Financing Considerations
With the projected market value in hand investors can plan their permanent financing scenario . Value-add deals often involve short term financing for purchase and renovations which is followed by refinancing into a long term commercial mortgage once the property is stabilized . Permanent financing typically operates on a loan-to-value (LTV) basis where lenders provide a loan based on the value of the stabilized property . Determining the total financing available involves multiplying the stabilized value by the LTV percentage .
Short term acquisition and construction loans usually work on a loan-to-cost (LTC) basis rather than LTV . Investors must confirm that the projected permanent financing will cover the short term loan balance and contribute additional capital if necessary .
Step 5: Construction Budget and Capital Contributions
Determining the acquisition and rehab budgets requires close collaboration with a general contractor or experienced professionals . Commercial lenders often offer combined acquisition/construction loans which ends up simplifying the financing process . These loans operate on an LTC basis considering the total cost of acquisition and renovations . It is essential to ensure that the permanent financing will cover the short term loan balance and account for any capital contributions required .
Step 6: Projecting Cash Flows and Exit Strategies
At this stage investors need to project the property’s cash flows throughout the investment timeline by considering debt service payments . By deducting debt service from projected NOI investors can determine the property’s cash flow until the exit . This information allows for the estimation of key metrics such as internal rate of return (IRR) and market value at the time of sale . Conservative estimates should be used for cap rates and cash flows to avoid overly optimistic projections .
Step 7: Evaluating Investment Criteria
The final step in the underwriting process is evaluating whether the projected numbers meet the deal’s investment criteria . Investors typically have specific criteria for returns such as a minimum desired IRR . By calculating the IRR using projected costs, annual cash flows and final sale proceeds investors can determine if the deal side with their investment objectives . If the numbers fall short negotiations for a lower acquisition price or considering other opportunities may be necessary .
Conclusion: A Step-by-Step Approach
While the details of underwriting multifamily properties may appear complex the process itself can be broken down into manageable steps . By following a structured approach and conducting thorough analysis investors can gain confidence in their decision-making and recognize viable investment opportunities .