Multifamily Deal Analysis: 3 Core Concepts You Must Know
Deal analysis is the process of looking at all the numbers for real estate investing and determining if it makes sense to go for it, raise capital for and operate the property for 2-5 years or longer as an investment.
In this article, we will focus on three components of real estate deal analysis here.
Growth in Rental Values
Multifamily deal analysis can be a complex process and it is crucial that you factor-in the key elements and do not fall into the trap of analysis paralysis. If you are evaluating a real estate deal, the first thing here is growth in rental values. So we are going to bring in some assumptions on our deal analysis process that we are going to assume i.e. there is going to be some increase in rent year-on-year.
Let’s say we look through the horizon of five years and hold on a project. We are going to go ahead and assume that rents are going to go up 2-3% per year. We are in an unprecedented long stretch of low interest rates that we have never seen before in world history, and potentially we are long overdue for a correction.
So you might model rent growth of 2-3% year over year, but you are also going to want to do a sensitivity analysis to show what happens if you have rent decline and what does that do to returns and what your break-even occupancy would be.
So this is just part of conservative underwriting. In your rent growth model we model 2 or 3% rent growth and we also model 2-3% percent expense increase in general. For taxes, we are assuming to be operating in Texas. Texas is a fantastic Market.
So we model substantially more for tax increase especially after taking over a property because we know that tax bills are coming. So we want to consider in that. But for other expenses like payroll things like repair maintenance or some of our other expense line items, we might see 2-3% increase year over year.
Exit Cap Rate
The next component in multifamily underwriting is exit cap rate. So cap rates have been compressed over recent years and it stands to reason that they may expand. If especially as we are going into kind of a rising interest rate environment here, nothing radical.
So that kind of puts things in perspective as 5% for interest rates levies on multifamily loans. In the scheme of things, it is still a very good rate. But we want to do on an exit cap rate. Let’s say we are buying a property at a 6% cap and we might sell it at same rate. And after 5 years we make a very good return of that but we don’t want to sell at a 6% cap. We want that cap rate going up in the future if interest rates rise and cap rates expand because they are very compressed right now and it stands to reason that they may not stay that way forever into the future.
So typically as part of an underwriting model you might see expanding over 5 year period, you might see expanding 10 basis points a year. So if you are at 6% cap at the purchase you might have an exit cap of 6.5 at exit and10 basis points a year to get to a higher exit cap rate if you have got room in your underwriting model, if you possibly can get it a full point 100 basis points over what you bought it at.
That’s just going to be cushion for you for your investors. And so we try to model as high of an exit cap rate as we possibly can. And that just creates cushion we want to be conservative in every component of the underwriting here. So seeing an exit cap rate that’s higher than the purchase cap rate is always a good thing.
The last thing here is the capex. This is just the capital Improvements to the property. There might be deferred maintenance on the property. You might have to go in and spend a million bucks on HVAC new parking lot, you know, maybe there are some electrical repairs. Maybe there is roof damage and obviously on a multifamily project.
Let’s save a hundred or two hundred unit property you can get into the millions of dollars on your capex. So you are going to go through on your due diligence with your contractor your team of inspectors or whatever the case is. You have got a team on come on that front end right after you put a contract on a property under contract to going and really crawl through the whole property walk every unit and put together a capital Improvement budget for that property that you might execute over 12 or 18 months.
And then what you are going to want to do is tag on probably another 10% or 20% if you can fit it in there because especially if you are buying a 70s property or even a 60s property. There are just going to be surprises on the property just like flipping a house, you get in there and start opening up walls. There are going to be surprises. You need to have a contingency on your capex budget.
I feel like 10% is reasonable more if you can fit it in there and the goal is just to be over capitalized on a project going in so that you never have to have a cash call with your investors. Nobody ever wants to hear their project ran out of money.
So you want to be over capitalize on your capex budget going in and that will ensure that that you just have that money in the bank there to go ahead and complete all those repairs. Now if you can work with your vendors or you can source materials cheaper, you can drive those costs down.
That’s great and that will improve the performance of the investment but you certainly don’t want to skimp on your capex or undershoot it.
So these are three components of multifamily underwriting.
When you are evaluating property you want to look for these things like what are the rent growth projections, are they projecting 4-5% growth in the future? This might be unrealistic exit cap rate, higher than the purchase cap rate because we have to account for the possibility of interest rates going up. In cap rates going up and then your Capital Improvement budget have some kind of contingency in it for overages and things like that.
So clearly there is more to multifamily underwriting than these three components.
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