How do private equity real estate firms know if an office or multifamily property is worth the investment risk? Will it turn a profit and increase in value, or underperform and lose money? That’s where underwriting comes in — the process of evaluating a property to determine its viability and potential.
When done right, property underwriting is a complex and rigorous process. It involves analyzing the consequences of hundreds of variables — from the assumed purchase price of a property relative to its competitive set to replacing HVAC to the cost of a fresh coat of paint. All these details can make or break the desired return and have a significant role in the real estate underwriting process. However, some have a greater impact on returns than others.
At Origin, we have developed a rigorous underwriting model to analyze every investment that goes into our private real estate funds. This not only ensures consistency and efficiency in our property underwriting, it increases our ability to make investments that will meet, or exceed, our expectations. While we look at dozens of variables, five of these factors play a more critical role when we’re analyzing any real estate investment we’re considering:
1. Rent Growth Forecast
Forecasted rent growth is one of the most important assumptions a real estate investor can make because this variable has a compounding effect throughout the duration of the investment. At Origin, we use industry-leading third-party data to help project the rent growth we can expect to achieve at the property over the life of our investment.
Another key concept that we consider is seasonality. This is pertinent to multifamily properties, where most leases are for one year and the demand for new leases peaks between the spring and the fall. Seasonality is a function, primarily from life-changing events (i.e., graduation, new job, marriage, weather, etc.), and in most cases is predictable in many markets over time.
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This predictability allows managers to push rents as demand spikes. Given most leases are signed on a 12-month commitment, it is important to realize what your lease expiration schedule looks like when acquiring a property as you don’t want too many lease expirations occurring in the slow leasing season of the market. However, it is also important to not assume all lease expirations occur in the high demand season, as this can overstate cash flows throughout your hold period.
2. Vacancy
There are two aspects to this variable: physical vacancy — the actual number of units or square feet that are empty at any given moment, and economic vacancy — or the loss of revenue a property will see due to units undergoing renovations, model or employees units, concessions or bad debt.
In every asset class, it’s critical to understand the significance of physical vacancy. The best way to forecast it is to look at the submarket level vacancy, comparable assets, and your property’s historical vacancy. At Origin, we also consider the local supply pipeline. Identifying the number of units or square feet coming online from comparable new developments in the foreseeable future plays a significant role in determining the occupancy and rental rates that can be achieved. Also, vacancy loss can be much higher at smaller properties as each unit or space accounts for a larger share of the property.
Economic vacancy accounts for the physical vacancy but goes deeper, accounting for loss-to-lease (down units or units that are leased below-market rates), model/employee units, concessions and bad debt. Due to Origin’s value-add strategy, we typically look to reposition assets within a three-year period. During this time, there will most certainly be loss-to-lease and potential concessions due to the improvements we make to an asset. It’s imperative to consider the amount of disruption there might be and how it will impact cash flow during the renovation period. Understating cash flow can lead to budget shortfalls that might require additional equity infusions, diluting potential returns.
3. Resetting Taxes
In most states, property’s taxes will most likely be reset based on its sale price anywhere from one to three years after the sale transaction occurs. An inaccurate forecast can affect future cash flows and impact exit price substantially, as taxes usually represent anywhere from 15-45% of the property’s total operating expenses. For example, we recently purchased The Fletcher Southlands in Denver, where the taxes were $500,000 for 2017. Below illustrates how the tax reset will rise significantly based on our purchase price calculation:
We estimate that the taxes will increase by roughly $100,000 after the property’s assessed value is reset. A $100,000 reduction in NOI will reduce the sale price by $2,000,000, at a 5% exit cap rate, and must be considered prior to formalizing the acquisition price.
4. Exit Cap Rate
A capitalization rate, usually referred to as “cap rate,” is the ratio of a property’s net operating income (NOI) in the first year of ownership, divided by its purchase price. It’s used to determine an appropriate “exit cap,” which is used to calculate the gross value of that investment property at sale.
The exit cap rate is an important variable in all investments, but especially the value-add properties we acquire at Origin. This is because we reinvest capital at the beginning of the hold period to improve the asset, which in turn lowers the property’s up-front cash flow. Knowing that cash flow is limited in the first couple of years, underwriting exit metrics is extremely important to achieve our expected returns.
At Origin, our approach factors in general capital markets risk in a rising interest rate environment. To determine our exit cap rate, we study current cap rates prevailing in the market for properties with similar characteristics. Once we identify where those cap rates currently stand, we increase the rate in our calculation by 2% each year for the duration of our hold period. For example, if we bought a new asset today in a market where comparable properties are currently trading at a 5.0% cap rate, we would underwrite an exit cap rate of 5.50% after year five. Building this “cap rate expansion” into our property underwriting models helps protect us from the risk of uncertain market conditions in the future.
5. Debt Assumptions
At Origin, we often use floating rate financing when we acquire properties for several reasons, but most importantly because it gives us the flexibility to pay off a loan penalty-free when we want to sell the asset. Conversely, fixed-rate financing often requires borrowers to pay a defeasance fee.
Another compelling reason to use floating rate debt is because our funds focus on value-add investments. This type of debt offers a source for future funding to cover some of the additional money needed for capital improvements and is generally provided by the same lender who provided the acquisition financing.
Finally, historically, floating rate debt has been less expensive than fixed-rate debt. That’s because forecasts of future interest rate hikes usually anticipate greater increases than what happens in reality.
There’s an important caveat to keep in mind when using floating rate debt: the rate that a borrower pays is based off a forward curve with a spread. Most frequently, the future rate is the one-month LIBOR curve. At Origin, we update our models each week to reflect the most current projections for the curve. When modeling a forward curve, it’s important to compute the calculation monthly to avoid underestimating debt payments, as this will result in a lower-than-expected cash flow and NOI.
Real Estate Underwriting Makes or Breaks Private Equity Investments
There are many more variables that go into underwriting than those mentioned here, and a simple miscalculation in just one can undermine the success of an investment.
At Origin, we take property underwriting a step further and group several different variables together and then synthesize the results. In turn, this allows us to see what a true downside scenario may look like. While these stressed situations are unlikely to occur as the business plan would change to mitigate these risks, knowing how far you can “stress” a property and still achieve an appropriate risk-adjusted return is important to understand. Knowing this allows you to see many or most of the potential issues and can help to avoid losing money on your investment.
Bottom line, it’s critical for investors to understand the assumptions an investment firm or asset manager uses in their underwriting model. Even the smallest miscalculation can have a profound effect on the returns of an investment. A rigorous property underwriting process helps to ensure that an investment will perform as expected, and that all opportunities are benchmarked against one another to determine those that represent the best risk-adjusted investments.
