Understanding a Sponsor's Underwriting Assumptions

When it comes to investing in multifamily real estate, understanding a sponsor’s underwriting assumptions and having realistic values to consider is extremely important. There are a number of assumptions and forecasts built into the data that a sponsor generates to project the returns for a specific project. Let’s explore what they are and why they are important.

Looking at the Numbers

The first step is to look at the property’s current in-place performance as this is the starting place for future growth. “In-place” performance is evaluated by annualizing the trailing 3-month and 12-month Net Rental and Other Income, along with the pro-forma year-1 Operating Expenses. Barvin uses pro-forma expenses when looking at in-place performance because property taxes will adjust based on the purchase price and can be anywhere from 15% to 30% of a property’s Total Expenses. Many sponsors make the mistake of not projecting higher property taxes even though their purchase price is higher than the property’s current appraised tax value. I see many of our competitor’s apartment investment offerings and hardly any of them include any mention of the property’s in-place performance or adjusted expenses. 

Historical performance and tax adjusted expenses are crucial to understanding the in-place cap rate. The cap rate is the post-closing Total Net Income divided by the Purchase Price. This data gives you a clear view of the property’s projected yield under new ownership and how the forecasted growth will build on the in-place numbers. In certain scenarios, the property may take 12-24 months to fully stabilize. This doesn’t mean that the property is a poor investment – the cap rate is only a portion of the analysis. Barvin has bought properties at low cap rates that have translated into great investments. One property, in particular, was bought at a very low cap rate because our view was that the rents at the property were under market. Over the first 3 years the rents grew by nearly 100% and as a result the property has proven to be a phenomenal investment.

It is also important to look at seasonal trends to accurately gauge the baseline for year one. For instance, if the property is being underwritten in September, the trailing 3 months of income are from the peak leasing season. That is why it is important that the underwriting analysis be adjusted to reflect Net Rental Income on an annualized basis. This is the same reason we look at trailing 12-months for Other Income - a lot of the Other Income line items (especially utility reimbursement) are seasonal.

Once one has a clear picture of the in-place performance, an investor should fully understand the assumptions and adjustments being made to arrive at the projected performance. The assumptions and adjustments should be simple and include all expected fees, such as property management and/or asset management fees.

Coming Up with End Result Numbers

When it comes to rent growth projections, data analysis software can help determine if the project is on the correct pricing trajectory, which directly affects the bottom line.

Looking at the overall economic situation, housing supply vs. demand, market economic situation, and published submarket data will also give the investor an idea of the amount of growth one can expect to see in the near future.

At Barvin, we adjust rents based on a variety of data sources combined with our teams’ operational experience. We recognize that underwriting is usually overly conservative in bad times and overly optimistic in good times. The COVID pandemic made predicting 2021 quite challenging, so on the most recent property investment, we underwrote it conservatively and estimated only 1.5% rent growth in year one, 2.5% in year two, and 3% in year three.

It’s important to understand what the sponsor does with these assumptions and if they take into consideration the following: Year over year rent increases, the percentage reduction of in-place concessions, and the projected occupancy level. It is also important that expenses be increased year over year as expenses always seem to increase each year. Barvin typically projects expense increases of 2% each year and property tax increases of 2.5% each year.

Financing and Underwriting

When investing in apartment communities, there are a few often overlooked things that one needs to consider before making an investment. 

What is the debt service ratio (DSCR) at closing and at stabilization? How long is the loan term? Does the loan term match the overall business plan, or will the loan need to be refinanced prior to sale? What are the sponsor’s assumptions? How will fluctuations in interest rates impact the underwriting analysis? 

A sales price or refinance value is based on the projected Net Operating Income (NOI) divided by the applicable cap rate. It is important to understand how the sponsor determined the projected NOI and what assumptions are being made about the refinance or sale. Asking about the sponsor’s projected leverage, cap rate, and interest rates will build a better understanding of their analysis.  

Barvin typically underwrites a higher exit cap rate than at acquisition, but the increase varies based on market and term. Note: the lower the cap rate the higher the sales price and, inversely, the higher the cap rate the lower the sales price, so using a higher cap rate is actually more conservative. That being said, cap rates have declined over the past 10 years and appear to be continuing to decline in 2021. Many believe that the cap rates are at historically low levels and likely to remain at this low level until interest rates begin to increase. Historically low cap rates have helped good investments turn into great investments. The real question is - who’s left with the bag when cap rates begin to rise in the future?

For the Investor

When looking at any property investment, insist on seeing a presentation (deck) on the property with all of the information required to make an informed decision, such as the historical data, the expenses, property taxes, etc. If you have not received this information, ask for it and it should be provided to you. The lack of a well presented, reasonable and documented deck is a major red flag.

A high-quality deck should explain why the property is a good investment. You should be provided supporting documentation for information for the following:

  • Expected Rent Growth
  • Taxes
  • Expenses
  • Financing
  • Hold Period
  • Expected Sale Value

A strong sponsor should be prepared to defend why they think their projections are likely to be achieved and should be open to your questions. If the sponsor is reluctant to answer your questions or seems upset by your asking questions that is another red flag.

Words of Caution

Investing of any kind has risks, and real estate is no different, but there are some things that you can look out for to help mitigate some of those risks.

Stay away from sponsors with unrealistic expectations. If they are telling you “we’re going to grow rents 10% per year and buy at 6% cap and sell at 3%,” that is very unlikely to happen.

They can’t just say that they’re going to raise the rent 10% each year - there needs to be a plan that will turn this into reality. They need to justify the execution and show you how increased rents are achievable.

Another thing to be careful about is the definitive price difference between different classes of apartments. For example, there is an approximate $200 per month rent gap between Class A and Class B properties, yet the Class B property sponsor is underwriting a $200 rent increase into their assumptions. If rents at your Class B and Class A properties are close, the occupancy at the Class B property will decline, resulting in reduced revenue.

Barvin’s Role

At Barvin, our philosophy is to be completely transparent with our investors. We will only offer properties that we genuinely believe are quality investments based on our in-depth analysis of the data, as well as an extensive understanding of broad markets and the exact sub-market. Remember, we not only invest as a Sponsor but also as a limited partner alongside our other investors.

We are long-term holders of real estate; we are not just investing in properties that we think will increase in value a year from now, we invest in properties that we think will increase in value over a longer period of time, sometimes 10 years or more.

The cost basis of a property is crucial when looking at investment opportunities. A properly priced cost basis buffers the downside risk and presents opportunity as operational improvements are achieved. Barvin is focused on opportunistic properties that are bought from motivated sellers and can be stabilized within the first couple of years. These properties will generate above market returns well into the future. We also seek balance as to how investors get their returns by providing returns from both cash flow and appreciation value; ultimately, our goal is that 60% of the investor’s returns come from cash flow.

For more about what to look for when investing in multifamily properties, check out our other recent blog here. To sign up to see future opportunities, please email investors@barvin.com.