You want to buy a certain property. However, before you can raise capital for this deal, you have a crucial task at hand: You must form your sales assumptions. That is, when you’re ready to sell this property, how much cash will you get?
You’ll make your sales projections at the end of the underwriting process, after developing your five-year business plan. And those sales assumptions will be included in your disposition summary.
Your apartment syndication investors will be especially interested in those assumptions. After all, the sale will provide them with substantial returns. In most cases, most of the profits come from the sale.
Because so much is at stake, you ought to be conservative with your sales assumptions. It’s better to reward your investors with extra profits than disappoint them with lower-than-expected returns.
At the same time, you don’t want to be too conservative. Higher sales projections make it easier to raise capital.
Where Do Sales Expectations Come From?
Let’s say you plan to buy a certain property for your apartment syndication, and you intend to retain ownership of it for five years. Thus, your projected hold period is five years. In most but not all cases, investors expect a projected hold period.
Now you must answer two questions: What will that property’s net operating income be at the end of the five-year period? And what will your exit cap rate be?
Divide your net operating income by your exit cap rate, and you’ll have your projected sales price, which should be equivalent to the value of the property in five years.
Next, you take your projected sales price and subtract your projected closing expenses. In addition, if you expect to still have a mortgage on that property in five years, subtract the amount of debt that you’ll owe your lender.
At this point, you’ll have your sales expectations.
But how do you calculate all of the numbers mentioned above? Well, let’s go through them one at a time.
1. Net Operating Income
The net operating income (NOI) estimation can be tricky. You’ll start with the property’s current stabilized income and expenses. Then you’ll factor in the extra income and extra expenses that you’ll incur over time.
For instance, as soon as you buy this property, you might renovate the building. Thus, you’ll need to figure out the cost of those renovations, how long they’ll take, and how much you’ll raise the rents afterward. That will give you a better idea of your NOI at the end of the first year.
Hopefully, with ongoing improvements and rent increases — and perhaps by lowering costs as well — your NOI will increase every year.
Note that we have other posts about underwriting that describe net operating income calculations in much more detail.
2. Exit Cap Rate
First, you can assume that your exit cap rate will be 50 basis points, or 0.5%, higher than your in-place cap rate when you buy the property. And, to ascertain the in-place cap rate, divide your NOI at acquisition by your purchase price.
Why do we assume a higher exit cap rate at sale? It’s just another way of being conservative. It takes into account that the market might be in worse shape at the end of the holding period.
If, however, it turns out the market is in better shape, everyone gets extra profits from the sale, and everyone is happy. However, you needn’t follow this advice. If you want to, you can guess that the market will be in the same or better condition in five years.
On top of that, two scenarios can make our exit cap formula inaccurate. First, if you buy a property below market value, you must divide your NOI at purchase by the actual market cap rate, not your in-place cap rate.
Second, maybe your property is distressed, and your renovations will be extensive. If so, you’ll want to use a cap rate that reflects the higher asset class your property will enter. To get that new cap rate, you could consult your broker or property management company.
3. Sales Price
To figure out what your sales price will be in five years, just divide your projected NOI at exit by your projected exit cap rate.
4. Closing Costs
Below are the closing costs to add up and then subtract from your sales price.
Your broker may charge a commission; be sure to ask this person what the amount would be. It could be a flat fee, but it’s likely to be a percentage of the sales price.
Your syndicator might charge a disposition fee; the standard amount is 1% of the purchase price.
Your mortgage might have an unexpired clause charging you three fees for selling: the pre-payment penalty, the yield maintenance, and the defeasance.
Your lender may charge you for ending your mortgage. Such costs are themselves known as “closing costs.”
There will be legal costs associated with ending an apartment syndication partnership, too. You’ll be enlisting the services of a real estate attorney or a securities attorney.
5. Remaining Debt
You can find your property’s remaining debt in two steps. First, subtract all of your principal payments from your mortgage’s initial loan balance. Then subtract that amount from your sales price.
When making these calculations, don’t forget to account for interest and amortization.
6. Sales Proceeds
Simply put, the amount of your sales proceeds equals your sales price minus your remaining debt and closing costs.
Finally, remember that a good cashflow calculator app can make all of your underwriting calculations easier and more efficient. Before too long, your sales assumptions will be ready. And, after that, a successful purchase will be a safe assumption.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.