Now you’ve found some deals, time to underwrite! This is a very crucial part of the apartment syndication business, as good/bad underwriting can make or break a deal. Listen to Theo and Joe’s best underwriting tips to get you started on the crucial part of apartment syndications. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!
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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.
Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series – a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.
Each week we air a podcast series about a specific aspect of the apartment syndication investment strategy, and for the majority of the series we will be offering a document or a spreadsheet or some sort of resource for you to download for free. All of these free documents, as well as the free Syndication School series of the past and the future can be found at SyndicationSchool.com.
You are currently listening to part two of a two-part series entitled “How to qualify an apartment deal.” In yesterday’s episode, which was part one, or if you’re listening to this in the future, the episode that was aired directly before this one, we introduced the three-step financial analysis process, which is 1) screening deals against your investment criteria, 2) underwriting a deal, and 3) performing due diligence on a deal. In part one we went through step one, which was the investment criteria. So if you haven’t done some already, listen to yesterday’s episode, which will take you through a four-step process to set your investment criteria. The reason why is because setting your investment criteria is going to save you from wasting time underwriting deals that you know don’t make sense for you based on your investment strategy. So definitely listen to that episode first.
In this episode we’re going to talk about steps two and three of the financial analysis process, which are going to be the underwriting and due diligence. Now, in yesterday’s episode I mentioned that these are not going to be the exhaustive episodes on underwriting due diligence; we’re kind of going in order here, and at this point all you need is that investment criteria in order to start looking at deals… But it’s going to be important to also understand what you’re going to be doing once you actually find those deals, so I wanna introduce underwriting, introduce due diligence, and then in the future once we get to those steps in the process, we’ll dedicate an entire series to underwriting, and dedicate an entire other series to the due diligence process.
Underwriting, step two. Deals that meet your investment criteria are going to move on to what’s called the underwriting phase. This is going to be the actual running the numbers phase. When you’re underwriting a deal, what you wanna do is you want to obtain the financial information from the seller. This is going to be the T-12, which is essentially a profit & loss statement for the previous 12 months of the property; so it’s got all of the income and all of the expense line items broken down into months. You’re gonna use that, as well as a rent roll, which is a list of all of the units at the property, and people living there, and how much rent they’re paying, or how many units are vacant, things like that.
You’re gonna use those two things and you’re gonna input them into a financial model, so you’re gonna need some sort of cashflow calculator. I believe we’re going to offer a cashflow calculator for free once we get to that phase. It’s not gonna be out super-detail customized cashflow calculator that we use for client, but it’s going to be a simplified version that still gets the job done and will allow you to at least have something to start with, and then ideally customize it yourself from there.
Anyway, so you’re gonna input your T-12 and rent roll data into your cashflow calculator to have an understanding of how the property is currently operating, and then based on your expertise, conversations with your property management company, understanding of the market, you are going to input information how YOU plan on operating the property… So what are the rents gonna be after YOU buy the property, what are the expenses going to be after YOU buy the property, what’s gonna be the debt service, what are gonna be the growth assumptions? …things like that. In doing so, you’re gonna essentially create a yearly, or ideally a monthly breakdown, or a monthly projection, for the entire whole period. If you plan on holding on to the property for ten years, then you’re going to have 120 different columns for each of those months during that time. Obviously, it’s gonna start off day one how the property is currently being operated, then you’re gonna totally transition it over 1-2 years to how you’re gonna operate the property, and then it’s gonna be smooth sailing from there, slowly increasing rents until you sell the property after ten years.
The most important aspect of the underwriting is going to be that 1-2 period where you are repositioning the property, assuming you’re a value-add investor. Moving forward we’re gonna be acting as if you’re value-add, because that’s what we do, and it’s what we always recommend people do.
What’s gonna be the most important during that underwriting is going to be that transition from how it’s currently operating to how it’s going to be like once you’ve stabilized the property at its new rents and at its new expense. A plus or minus 5% there is gonna sway the property values, which is going to sway the exit sales price, which is gonna mess up the return projections to your investors. So that two-year period of projections is very important, and again, we’ll go over in detail how to make sure you’re doing that properly.
Once you’ve inputted all that data, then you are going to do an iterative process – set an offer price that results in returns that meet your and your investors’ return goals, and then that’s the offer that you’re gonna submit to the owner. So the underwriting process starts with “Does this property meet me investment criteria?” Yes, to inputting information into your cashflow calculator, to it spitting out “This is how much money you can pay for the property”, to submitting an offer.
Now, at this point in the process – and this is very important – the important outputs of the cashflow calculator, which if you remember all the way back in maybe one of the first Syndication School series, we said that the main focus is going to be that internal rate of return and cash-on-cash return… These are going to be projections, and they’re not going to be exact values, because obviously you can’t predict the future, so you don’t know exactly how the property is going to operate once you take over. The goal is to get as accurate assumptions as possible at this point, so that you can submit a fair offer. Then once you do your due diligence, which is step three, you are going to make these assumptions even more accurate, but they’re never going to be perfect. So the goal is to get them as perfect as possible, but also knowing that they’re not going to be exact values, especially in underwriting; they will be more exact after due diligence, but still not perfect.
Before moving on to the due diligence and finishing up the episode – this is gonna be a short one – I wanted to go over some tips for underwriting value-add apartment communities. We’re kind of going out of order here a little bit and I’m jumping ahead to underwriting, but I’m gonna assume that you guys have some understanding of underwriting properties, even if it’s just underwriting fix and flips, so you’re gonna understand some of this terminology. If you don’t understand the terminology, I recommend going to our blog and looking up the glossary of apartment syndication terms, because the definition of all these terms are going to be found there… Because I don’t wanna stop every two seconds and define the terms that I’m using.
That said, here are some of the top tips for underwriting value-add apartment deals – it’s going to be ten. Some of these I might have already hit on already, but I’m just gonna do them in order anyways. Number one is a tip on how to calculate the offer price. You do not wanna base your offer price on how the property is currently operating. This is something that people typically do on smaller 2-4 unit buildings, where they’re gonna be like “Okay, here is what the rents could be, and here is what I think the expenses are going to be. Based on that, there’s gonna be an NOI of whatever, and my debt service is gonna be this, so it’s cash-flowing $10,000/year. Based on my down payment of $100,000 – 10% cashflow. Great! I want that.” You don’t wanna do that, because you have to take into account how the property is going from how it’s currently operating, to it being how it’s gonna operate once you take over, and it’s not gonna be instantaneous, which means that you also can’t base your offer price on how the property will operate once it’s stabilized. You can’t say “Okay, these are what the rents are going to be, these are what the expenses are going to be, here’s my offer price.”
I guess I might have mixed up the first one, when I said “Don’t base your offer price on how the property is currently operating.” So what you don’t wanna do is be like, “Okay, the rents are this right now, and the expenses are this right now. This is how much I wanna buy the property for.” So you don’t wanna do either of those. What you actually wanna do is you wanna base your offer price on the projections for the entire business plan. You’re going to want to say, “Okay, year one it’s gonna cash-flow this much. Year two it’s gonna cash-flow this much, after I’ve done my renovations. Year four it’s gonna cash-flow this much, year five, year six, year seven etc, and then year eight I’m gonna sell this property, and I expect to sell it at this much based on what the rents are going to be, so I’m gonna make this much extra cashflow at sale. That way I’ve gotten this total annualized cashflow of 25%, which is what I want, so I’m gonna set my offer price based off of this deal over eight years cash-flowing an annualized 25%.” That’s the best way to set an offer price.
I guess you could technically follow those other two strategies, but your return projections are going to be way off if you base it on how the property is currently operating, or if you base it on how the property will operate once it’s stabilized… Because that is not going to be the state of the property for all eight years; it’s going to be different.
Number two is going to be don’t trust the offering memorandum. Again, the offering memorandum is going to be a sales package – keyword being “sales” – put together by a broker for an apartment deal that is mass-marketed. Most likely, you’re going to be e-mailed a new deal, and they’ll say “Click here for the offering memorandum”, and you’re gonna go through the offering memorandum. There’s gonna be all these fancy charts and graphs and pictures, and all these statements about how great this deal is, as well as a breakdown of how they are predicting the property to operate for the next five years.
You don’t wanna base your offer price on that proforma. Again, you wanna base it on the T-12, the rent roll, and your stabilized assumptions, so how you are going to operate the property after you’ve taken over, based on how it’s currently being operated, and projecting that out for however long you plan on holding on to the property.
Tip number three is about how to determine the rent premiums. The rent premiums are — and I guess I am going through and defining these terms… [laughs] So the rent premium is going to be the amount of extra rent you can demand after taking over the property. For example, let’s say that I am buying an apartment of all one-bedroom units that are rented for $700, and my plan is to go in there and spend 5k/unit in renovations, and — let’s take a step back… Let’s say I read the offering memorandum and it says that you’re gonna need to spend $5,000 in renovations and you will be able to raise the rent by $200. Great! So I just input that in my cashflow calculator, right? $200, $5,000/unit – boom, I’m done. Well, no. You need too 1) confirm that $5,000 number. That means going to the property, looking at the interiors and saying “Okay, this is exactly what I need to do. Okay, based off of that, how much is it going to cost?”
Then you also need to perform a rental comparable analysis to look at comparable properties in the markets, with units that are comparable to what your unit is going to look like after it’s renovated, and determine how much rent per square foot they are getting. Then use that rent per square foot, multiply it by the square footage at your building to get a new rent, and the difference between that new rent and that old rent is going to be that rental premium.
Now, besides rental comps, the only other way to determine a rental premium is if the current owner already has proven rental premiums. So going back to our one-bedroom example, let’s say I’ve got a 100-unit building with all one-bedroom units, that 50% are not renovated, and they’re renting for $700, and then 50 units are renovated, and they’ve been renovated within the past 12 months, and they are renting for $850. Then you wanna confirm through your rental comp analysis, but you can be pretty confident that your rental premium on those remaining 50% of the units is going to be $150, because they’ve proven that for 50 units.
Now, since we’re talking about rent comps, tip number four is going to be about rent comps, which is “How do you actually perform the rent comps? What is a good rent comp?” The factors that you wanna look at when you are analyzing comps are 1) what was the construction date of the property? That needs to be comparable. What is the distance away from the property? This is also very important, because a property could be a mile away, but in a completely different type of neighborhood, especially if you’re in a big city. Also the number of units, because a 50-unit apartment building is not going to offer the same amenities as a 200-unit apartment community. So you’re not gonna be able to use a 200-unit apartment community as a comp for a 50-unit, as an example.
Also the unit type and size. Depending, for example, if you’re looking at a comp that has massive walk-in closets, it’s got a dining room, it’s got a living room, it’s got a den, and an office, and then two bedrooms and one bathroom – that’s not gonna be a good comp if you have just a two-bed/one-bath with a super-small kitchen, and just the living room and those two bedrooms and that’s it.
Also – this is kind of obvious, but the unit upgrades. An apartment with granite countertops and stainless steel in the kitchen is not gonna be a good comp if you plan on only putting in white appliances and laminate countertops. And also the amenities offered at the property. What you wanna do is create an amenities checklist for all of the amenities at the subject property, plus whatever you plan on adding in, and then when you’re looking at comps, add that comp to your checklist and check off how many amenities match, and which extra ones do they have, and if they have a pool, and a barbecue area, and a dog park, and a business center, and a clubhouse, and then your property has none of those, it’s not gonna be a good comp.
Now, this is when you’re either looking at off-market deals, you’re gonna find your own comps, or if the broker has really bad comps, you’ve gotta find your own comps… So in order to determine if the broker has bad comps, here are three things to look at; these are all based on what I’ve already said. Number one, the distance to the property. Number two is the year the property was renovated and the renovation timeline. That timeline should be similar to the timeline you plan on implementing yours. If you are looking at a comp, or even your subject property, and they are saying that they’ve got a proven rental premium of $150, but they’ve only renovated one unit, or they renovated 20 units over a five-year period, that’s not a good comp.
And then lastly, you also wanna take a look at the property operation. For example, who pays utilities? If at the subject property (the property that you are gonna buy) the owner only pays for water, but then you’ve got a comp where the owner pays for everything, that’s not gonna be a good comp, or at least you have to adjust for that extra money that your tenants are gonna be paying that is not necessarily going towards the rent. So that’s tip number four about the rental comps.
Tip number five is that you want to confirm all of your underwriting assumptions with your property management company. They’re the ones that are operating the property, they’re the ones that are gonna need to stick to that budget, so they need to approve that budget before you close on the property. So when you’re underwriting a deal and you input all of your assumptions, make sure you run that by your property management company before you submit an offer. They might see something that you didn’t see, they might know something you don’t know, and they might have you tweak something that might save you from buying a bad deal.
Tip number six is going to be about the revenue or the income line items. In regards to rents, when you’re analyzing a deal, make sure you are inputting market rent information, and not the actual rents. When you look at the rent roll, there’s going to be the rent that is actually being paid – so it might just say “Rent”, it might say “Current Rent”, it might say “Collected Rent” – and there’s gonna be another column that’s gonna say what the market rent is, and the market rent is what that unit should be rented for. Sometimes the current rent and the market rent might be the same, but more than likely the actual rent is gonna be lower than the market rent. The reason why that’s important is because that is going to be a potential value-add opportunity. So if the market rents are $800, but the owner is only renting the units out for $700, then you’ve got $100 in there that you can get by just turning over the units at their current condition. Add in there your $150 rental premium and you’re raising rents by $250, rather than just $150. So it’s important to know what the difference between the market rents and the actual rents are, which is actually called loss to lease. So on a T-12 you might see LTL or Loss to Lease, and that’s what they’re referring to – that’s the difference between the market rents, aka the amount of rent they could demand for that unit, versus the amount of rent they’re actually demanding. That difference is loss to lease, and ideally that’s gonna be around 2%-3%, because if you think about it, if I were to rent out a unit today at $500, and rents go up by 3% each year, then at the end of their lease after 12 months that unit is now worth $500 plus 3%. But since I can’t raise rent during that 12 months, there’ll be that 3% loss to lease. But if it’s anything higher than that, then something else is going on.
You also wanna know the difference between the economic and physical occupancy. Physical occupancy is the rate of occupied units. If there are 100 units in the building and 80 are occupied, then the physical occupancy is 80%. But let’s say that of those 80 units maybe ten of those people aren’t paying rent at all. Only 70 units are actually paying rent, so the economic occupancy is 70%. So the physical is 80%, economic is 70%. 70% is actually based on how much money you are collecting, whereas that 80% is not necessarily a reflection on the amount of income you’re producing, because 10 of those units aren’t actually paying any rent.
That’s a pretty important distinction when you are looking at deals, and when you’re inputting vacancy, you wanna input the economic vacancy, or the vacancies loss, so how much money is being lost on those vacant units, as opposed just to how many units are vacant in general.
And then lastly for the vacancy rate, you wanna make sure that – since we’re doing value-add, the vacancy rate is going to be higher during renovations than post renovations… Because every time you’re renovating the unit, it’s vacant. Once all the units are renovated, then you’re gonna have much less vacant units, unless something else is going on in the market. So that’s tip number six, about the revenue line items.
Tip number seven is gonna be about taxes. Obviously, one of the biggest expenses for real estate, ongoing and at sale, are the taxes… And you wanna make sure that you are basing your tax assumption on the purchase price, not based on what they are currently paying. Because what you’ll see on many properties is that they will have their T-12, and the taxes will be, let’s say, $500,000 for the year, but that’s based on a tax appraisal from five years ago, when the property was worth 70% of what it is now.
You need to go to the appraisal or auditor site, find out the tax rate, and multiply that out by your purchase price to get the new tax expense. Sometimes you’ll see that the taxes go up by quite a bit. They could be going up by multiples of hundreds of thousands of dollars, depending on the property type and how long ago the property was audited.
Number eight is gonna be about renovations. When you are looking at interior renovations, a few questions you wanna ask yourself are “How many units were renovated by the current owner? What percent of the units were renovated by the current owner?” and then you wanna know what were the unit upgrades. What did they actually do to these units? Then you wanna know if you will be replicating what they did, or if you’re doing less or doing more. That will help you determine a cost.
Then for the rental premium that comes from those interior renovations, the two questions you wanna ask yourself are “What period of time were those units renovated?” As I mentioned, 20 units renovated in two months is different than 20 units renovated over two years. The rental premiums of the two months are going to be way more accurate than the rental premiums of a two-year renovation timeline. And of course, you wanna know what premium was actually achieved based on those interior renovations.
Then to determine your exterior costs, really the only way to do that is to visit the property in person, preferably with your property management company or the general contractor. So again, for interior essentially you just need to figure out what the current owner did to the property, if anything. If they did do something, are you replicating it or are you going to do something else? And then if you are gonna replicate it, what was the timeline of those renovations and what was the rental premium? The idea is to figure out how much to spend on interior renovations, as well as to get an idea of that rental premium.
The last two are pretty quick. Tip number eight is going to be about the operating account fund, so make sure you have upfront reserves that are equal to 1% to 5% of the purchase price. That’s going to be to cover unexpected issues that come up during the first couple of years before you can create your reserves from the ongoing cashflow. You need to have those reserves upfront to cover things, so you don’t have to do a capital call if, God forbid, something massive comes up.
Then lastly, it’s about the disposition assumptions. When you’re underwriting a deal, you’re going to have sales assumptions. The most important sales assumption is going to be what will be the cap rate. You’ve got your budget, you know what the NOI will likely be at sale, and the other factor you need to determine the value of the property is gonna be the cap rate, so what the exit cap rate is. There are a lot of different strategies for determining and setting an exit cap rate assumption, but what we do is we add 20 to 50 basis points – that’s 0.2% to 0.5% – to the in-place cap rate.
If the current NOI of the property is 100k and we’re buying the property for two million bucks, then the in-place purchase cap rate is going to be 5%, so we would assume that when we sell the property the cap rate will be 5.2% to 5.5%. That’s what we will input in our cashflow calculator, which will determine the amount of money we will make at sale, and obviously that’s being distributed to our investors, so that impacts the return projections as well.
So those are the ten tips for underwriting. Again, I’m gonna spend an entire series focused on the underwriting process in great detail, and you’ll definitely receive some sort of free document to help you get started with your cashflow calculator… But continuing on with that 100/30/10/1 process, for every 30 deals that meet your investment criteria, expect about 10, so one third of those will actually end up meeting your investment criteria and warrant an offer.
Now, once you submit an offer, and if it’s accepted, then you move into what’s called the due diligence phase. This is gonna be step three of the financial analysis process, the last step before closing. This is the phase between the contract and the closing. The purpose of the due diligence is to confirm all of those assumptions that you made during the underwriting process, so that you can determine if the deal still meets your investment goals.
During this period, you’re gonna have the property inspected, your property management company is gonna do a bunch of audits on the current operations, you’re gonna have an appraisal, people are gonna come survey the property… And all of these different inspections, audits, appraisals and surveys will generate reports that you will then review, and based on the results on those reports you’ll go back to your financial model and update or confirm the input assumptions, which will give you a much more accurate five-year or seven-year (or whatever your hold period is) projections. Based on that, you can at that point ask yourself, “Okay, after due diligence I’ve got all these documents, all these inspections, I know to a higher degree of accuracy what the cashflow will be for 5, 7, whatever your hold period is. Does this deal still make sense?” And again, I’m gonna dedicate an entire series to going over what those reports are, what they mean, how much they cost, how to analyze them, things like that… But for now, just know that you’re gonna get all those things, and then for every ten deals that you submit an offer on, expect that you will only close on one. That means that all those ten deals that you submit offers on, one of those will have the offer accepted and will pass that due diligence intensive analysis phase and be closed on. So those are the three steps.
The last thing I wanna talk about is a general timeline, so you know what to expect for each of these steps. For setting your investment criteria, it could take anywhere from a few months to a few years, because as you know — I think we’re on series number nine right now, so we’ve done eight other series on apartment syndication, and so before you even get to the point where you can set your investment criteria, you need to go through all those eight steps first. You need to get educated, you need to get experience, you need to set your goals, you need to build your brand, you need to get a team, you need to get passive investors. So depending on where you’re at, you might be able to do all of that in a few months. Unlikely, but you might be able to do it in a few months; more than likely it will take you six months to a year, but if you don’t have any experience, then you might need to spend the next 12 months getting experience before you even start the syndication process, and get to the point where you can make your investment criteria. That’s why I said a few months to a few years, depending on where you’re currently at.
For the underwriting – underwriting a deal could take anywhere from a few weeks to a few months; typically, for on-market deals at least, when they’re listed for sale, the call to offers date usually isn’t for about a month. For on market deals you could be submitting an offer within a few weeks, up to a month, maybe two months; for off market deals it could be a year before you negotiate an offer with the owner. Then the due diligence phase, again, is negotiable, but generally it’s going to be 60-90 days. So contract to close is going to be 60-90 days.
That concludes this two-part series about how to qualify a deal. Again, we didn’t go into extreme detail; we just did an overview just to introduce you to the concepts of underwriting and due diligence, which was in this episode… And in the last episode we did go into detail on how to set your investment criteria, because that’s what you actually need in order to start looking at deals.
In this episode, again, we went over the ten underwriting tips and described underwriting a little bit, and we also gave you an overview of the due diligence, which is step three, and then we gave you an overall timeline for this financial analysis.
That concludes the episode. To listen to part one and the other Syndication School series about the how-to’s of apartment syndication, and to download your free documents, visit SyndicationSchool.com.
Thank you for listening, and I will talk to you tomorrow on Follow Along Friday.