9 Steps For Analyzing and Underwriting a Multifamily Real Estate Deal
The multifamily investment space is on fire right now. And that’s great if you already own a property, but it makes breaking into the investment niche or finding additional properties that much more difficult.
Cheap debt, rising inflation, and turbulent equity markets have investors looking for alternative investment opportunities. And the world is waking up to the benefits of investing in real estate.
COVID has changed the parameters, too – some markets have seen year-over-year rent growth above 20% due to evolving domestic migration patterns, rising input costs, and surging demand.
In response, multifamily syndicators and real estate private equity firms are coming out of the woodwork. They’re all chasing the same opportunities – many boasting no fundamental unique value proposition other than their ability to “more quickly or aggressively analyze” a property than the competition. Demand has even gotten so crazed that some investors are keen to throw underwriting fundamentals out the window if it means they can get their hands on a property.
But there is a real risk in getting swept up in the frenzy. Sure, many investors who "overpay" for an asset will be okay, but there are others who will unquestionably not be so lucky.
The key to achieving quality, long-term, risk-adjusted returns begins by buying a property right. Consequently, it's critical to rigorously underwrite an investment opportunity using a repeatable and quantifiable metric-driven approach.
So that’s what we’ll focus on here. This article dives into the 9 most important steps you need to take when analyzing and underwriting a multifamily real estate deal – in any market, during any economic cycle, and under any circumstances.
9 steps for analyzing and underwriting a multifamily real estate deal
1. Have a firm grasp on the rent roll and other property revenues
All multitenant real estate investment properties have what's called a rent-roll. A rent roll offers detailed information about the property’s tenants, a high-level overview of essential lease terms and expirations, and rental figures. It will quickly give you a good snapshot of a property's gross rental income as an investor.
In addition to a rent roll, it’s also important to understand the property’s other revenue collections. An income statement should highlight these additional revenue line items – amenity fees, parking and pet fees, and storage rental fees, for instance.
The property's top-line revenue figures will serve as the benchmark for the remainder of your analysis and underwriting.
2. Compare in-place revenues against market averages
As an investor, it’s safe to assume that a landlord maximizes a property's revenue potential, right? Well, if you've spent any time in the business, you've probably realized that's often not the case.
Not all property owners are created equal, and there are various reasons why a property may be under-rented. For example, landlords can be lazy and uninformed or may even have personal relationships with tenants and offer rent breaks and concessions. But by comparing in-place rental income against market averages, you may uncover opportunities to increase revenue without any updates or renovations.
Market rents are primarily dependent on what prospective tenants are willing to absorb. There are a couple of key indicators to consider:
- What are other landlords charging for similar space (property class, quality, size, bedroom/bathroom count, amenities, etc.)?
- Is the rent net of expenses? For example, sometimes landlords include utilities and HOA fees in the total rental figure.
- Are the units furnished?
- The durability of the area's single-family rental market.
Determining market rents is often as easy as perusing public resources like Craiglist and Zillow. Property managers and the MLS can be a great source of data as well – they’ll offer insights into asking vs. actual rental rates and standard industry practices.
Real estate consultants aggregate large amounts of rental and tenant data for specific markets for a more comprehensive outlook.
3. Identify in-place expenses and allocate additional capital for your cap-ex budget
Once you grasp a property's revenue streams, you need to account for any in-place expenses. A previous year’s income statement should provide historical expense data, but those line items often don’t tell the whole story. As you’re building your proforma, it’s important to consider several variables when projecting future expenses:
- Did the owner self-manage the property or outsource it to a property manager?
- How are the units metered for utility purposes? This could impact which utilities the owner is covering and how expenses are broken down by unit.
- Will property taxes be reassessed upon sale?
- Is the owner writing off any uncommon expenses against the property?
In addition to accounting for operating expenses, you’ll also want to consider a budget for capital expenditures outside of routine repairs and maintenance. The quality of a property and any outstanding or deferred maintenance obligations will largely dictate how much you’ll want to budget monthly for Cap-ex.
Major cost items like roof and HVAC replacements can break your budget if you haven't adequately accounted for them.
4. Consider vacancy and rental growth rates
The rent roll will offer some insight into the property's historical and current vacancy rates. That data can be misleading, though, especially depending on the diligence with which an owner-managed the property. For example, a well-managed and adequately maintained property will generally have a lower vacancy rate than a poorly managed site.
Another factor to consider is the market’s vacancy averages across similar multifamily properties. Most properties don’t operate at 100% capacity, so it’s important to make assumptions on future vacancy rates based on comparable market data and your specific management plan.
Rent growth, on the other hand, is slightly more out of your control as an operator. In more mature, stabilized real estate markets, it's common to see a consistent upward trend between 3-5%. However, some high-growth markets can see rent growth between 5-10% or greater, depending on critical underlying economic drivers like population migration and underlying construction costs.
5. Determine renovation and construction plan
Your renovation and construction plan will be primarily dictated by your overall management plan and investment timeline. Many multifamily investors seek what are known as value-add properties – there is some in-place cash flow. Still, more importantly, there’s the opportunity to increase rental income through renovations and updates.
Do you see value-add potential in the property and plan to update units and amenities to capture a higher rental rate? If so, you’ll want to need to understand the component costs of any construction, both hard and soft costs, in addition to any interest or preferred return financing expenses for the additional capital requirement.
Once you’ve developed a preliminary construction budget, it's crucial to analyze the timing of those expenses – the renovation timeline will impact when you push unit rents and stabilize rent rolls, in addition to your return metrics and proposed divestment timeline.
6. How will you finance the project?
With historically low-interest rates and the relatively inexpensiveness of debt options, many multifamily investors opt to finance projects using predominantly debt sources. Leverage allows a real estate investor to exponentially increase their returns using borrowed capital and scale their portfolio quicker than they could otherwise.
And while going to a lender and getting a traditional bank note makes sense in some circumstances, most investors opt to bridge gaps in their capital stack using other means of funding. From non-traditional debt funding to equity crowdfunding and syndicated financing, various alternative debt and equity sources are available to an investor.
As you formalize your capital stack and determine how you’ll fund the project, keep in mind that each type of financing has its own unique cost of capital - equity financing is generally more expensive than a comparable debt instrument.
And to accurately forecast your returns, you’ll need to account for some of the other financing parameters – the timing and size of any preferred returns, interest payments and any interest-only periods, and any balloon payments and refinance assumptions.
7. What will your property generate after renovations and value-add activities?
Whether it's more aggressively managing an under-rented property or raising rents after you renovate the units, the goal of any value-add activities is to capture the upside of being able to charge higher rents.
But those kinds of management strategies don’t yield results overnight. It can take several years to stabilize a failing property, and any construction timelines will dictate when you raise rents on the back end of a project.
The scale and timing of those rental rate increases need to be captured when you’re underwriting a multifamily deal. They’ll impact your project cash flows as well as any financial metrics used to assess the profitability of a project.
8. Plan 2-3 exit strategies based on your investment philosophy
Before ever buying a property, most investors and investment funds develop what’s called an investment philosophy. In short, an investment philosophy outlines an overall investment strategy – codifying everything from personal and fund risk tolerance, to the characteristics of an ideal property, to the preferred payback and hold period time horizon.
That philosophy should guide an investor’s capital budgeting decisions and offer a quick litmus test for choosing to pursue a deal or not. Too often, investors chase deals that look good on paper but don't align with their investment philosophies or timeline preferences.
Did you know that many multifamily investors underwrite deals with an underlying 2-3 year refinance assumption? That’s a great sales tactic when pitching limited partners on a capital contribution return timeline. But the world may look very different in a couple of years, and a bank's appetite to lend may not be as bullish as it is today. And that's a big gamble if you've structured your only project exit strategy on a significant unknown.
Proformas are malleable and can be largely manipulated to make a deal look as favorable or unfavorable as you please. Don’t pigeonhole yourself into a strategy or deal that doesn’t align philosophically or only offers a single exit.
Instead, it would be best if you define your philosophy early, aggressively chase deals that meet your criteria and structure a deal to offer several possible exit strategies based on your risk tolerance and timeline preferences.
9. Wrap it all up in a proforma and consider return parameters
Once you’ve identified a property’s relevant cash flows and accounted for any renovation/value-add activities and financing costs, you can wrap all that data up into a proforma. A 10-year proforma will help you forecast the multifamily property's financial performance over the project's life.
Based on your investment strategy or target return parameters, you can solve for a purchase price using your proforma and underlying assumptions. Several critical financial metrics commonly guide investment decisions:
Internal rate of return (IRR): IRR is the deal’s estimated rate of return, given a set of cash flows, for a multifamily property over the life of the project. Investors commonly have IRR benchmarks they use to back into property valuations or purchases prices. For instance, let’s assume your IRR target is 15% over a 5-year project. Based on projected cash flows, a 15% IRR equates to a property valuation of $1 million - suggesting the most you can offer for the property is $1 million to meet your return parameters.
Cash on cash return: Cash on cash return is a benchmark used to measure the actual before-tax cash earned on the total cash invested in a property. It's relevant, mainly when debt financing is used to supplement a cash infusion, to determine the efficiency of your invested capital in a project. Using your proforma, a purchase price can be similarly "backed into" by solving for a target cash on cash return threshold over the project's hold period.
Net present value (NPV): Net present value measures the present value of all net cash flows over the life of a project. In isolation, NPV lacks context, but comparing the net present values from two separate projects can help you compare relative profitability and enables the capital budgeting decision-making process. For example, if one multifamily project has an NPV of $1 million and another has an NPV of $1.2 million, logic would suggest you engage in the more profitable project.
The role of a real estate consultant and advisor
Because the world of multifamily investing is so crowded, it requires nuance and skill to source opportunities, quickly analyze and underwrite properties, and win deals. Marsh & Partners has experience as an operator and investor and a broker and advisor to different kinds of multifamily and real estate investment transactions.
We’ve made mistakes with our own money – but those lessons learned position us to guide clients more effectively through their own multifamily acquisitions and dispositions. Our multifamily investment services include:
- Advising clients on negotiating and winning more deals
- Investment philosophy development & methodization
- Deal analysis and underwriting
- Deal structure and project exit planning
- Redevelopment/re-use advisory
Learn more about our real estate consulting and investment advisory services here.