- Underwriting a commercial real estate investment requires that an investor make a series of assumptions about things that will happen in the future. These assumptions can have a material impact on the success or failure of the investment.
- The property’s purchase and sale price impact how much money needs to be contributed to the investment and what the potential profit is.
- A property’s vacancy rate estimates what percentage of the space is unoccupied throughout the year.
- Rent and expense growth rates indicate how much both are expected to grow on an annual basis
Prior to making a commercial real estate investment, one of the most important tasks on a real estate investor’s to-do list is to create a financial projection of the property’s cash flows and Net Operating Income (NOI). This process is known as “underwriting” the property and the resulting financial projections are displayed in a document called a “proforma.”
One of the most challenging aspects of underwriting a commercial property investment is that the holding period can range from 5 – 15 years. Projecting income and expenses over this time period requires the underwriter to make a series of assumptions about future property and economic conditions. Often, the success or failure of the investment hinges on the accuracy of these assumptions so it is critically important that they be conservative.
For individual investors looking to make a commercial real estate investment, there are five critical assumptions that should be tested and challenged as part of the underwriting process.
Assumption #1: Entry & Exit Cap Rate
Perhaps more than any other variable, the property’s purchase and sale price are the biggest drivers of investment return metrics.
The entry capitalization rate (“Cap” Rate) is calculated by dividing the property’s year 1 Net Operating Income by the estimated purchase price. This cap rate should be compared to recent sales for similar properties to ensure that it is reasonable. More importantly, the entry cap rate also provides a reference point for the exit cap rate.
The exit cap rate is a choice made by the underwriter to determine the sales price at the end of the investment period. It should be informed by the entry cap rate and adjusted for estimated market conditions at the time of sale. It is critically important that the exit cap rate assumption be conservative because the ultimate sales price has a meaningful impact on the total returns for the investment. As a general rule of thumb, investors should look for a 2% – 3% increase in the cap rate for each year of the investment holding period. So, if a property was purchased with an entry cap rate of 6% and the estimated holding period is 10 years, it would make sense for the exit cap rate to be in the 7.2% – 7.8% range. This increase would account for the uncertainty in future market conditions.
Assumption #2: Vacancy Rate
When investing in a multi-tenant property, it is a given that there will be some vacancy during the holding period. To account for this, the underwriting model needs to include a line item for vacancy.
The vacancy assumption is driven by a number of data points including, the property type, tenant quality, number of units, location, supply and demand, and general economic conditions. Physical vacancy, meaning the number of empty units, impacts a property’s gross rental income and its ability to fund its operations so it should be minimized to the extent possible.
In a value-add investment, vacancy may start out high as the property is being repositioned, but it should stabilize over time. As a general of thumb, stabilized vacancy should be estimated at 5% – 10% of gross rental income. Anything significantly different than this should be justified with as much data as possible.
Assumption #3: Rent and Expense Growth
Over a long period of time, inflation drives the cost for goods and services higher. A proforma should reflect this.
Aside from inflation, rental growth can be driven by a variety of factors including market supply and demand, seasonality, economic conditions, and property location. To account for these, a proforma should include an income growth assumption. As a general rule of thumb, it should be in the range of 2% – 3% annually. Anything appreciably different needs to be fully supported by market data.
Operating expenses are also driven higher by inflation. As such, an assumption needs to be made about their growth as well. Some expenses, like landscaping and maintenance can run on multi-year contracts so they can be reasonably simple to forecast. Other expenses like property taxes can have significant increases after purchase, which must be considered. Further, other expenses like utilities and property management are variable. To account for this variability, a general expense growth assumption must be made. Generally, many proformas will assume a 2% expense growth rate, but it should not be higher than the income growth rate for the duration of the investment.
Assumption #4: Financing Terms
Using debt to purchase a CRE asset can help to boost returns. But, it also raises the risk profile of the transaction because the terms can change over the holding period.
In order to accurately model the cost of the debt, it is necessary to know all of the loan inputs like interest rate, term, amortization, loan to value ratio (LTV), and loan amount. These factors will impact the calculation of the required monthly payment, which is one of the most important proforma inputs.
In addition to the loan terms, it is also important to know whether or not there will be any loan covenants that require the property meet certain tests during the term of the loan. For example, it is common for a lender or financial institution to implement a debt service coverage ratio (DSCR) covenant that requires the property’s income to be 1.25X the loan payment at all times. If there is a shortfall, it is a technical default and could mean that the lender calls the loan. Proforma results should be considered in the context of potential loan covenants.
Assumption #5: Capital Expenditure Reserves
Things break and the property’s physical condition degrades over time. As a result, things need to be replaced and renovated. The cost associated with these improvements can add up. To account for them, a certain amount of money should be set aside from the property’s operating income each month as reserves to pay for these future expenses. The exact amount varies by property type and size. For example, a common rule of thumb is $250 per unit, per year for a multifamily apartment building.
Failure to account for reserves can cause issues down the line if a major repair becomes necessary and there are no funds available to pay for it. Reserves should be adequately funded to avoid this issue.
Summary & Conclusion
Constructing a property proforma is part art and part science. It is science in the sense that there are generally accepted principles upon which it is constructed, but it is art because it is fundamentally just an estimate built upon a series of assumptions.
To ensure the assumptions are as accurate as possible, they should be conservative, based on market data, and within the generally accepted bounds of proforma construction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.
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