Underwriting

- is the process of paying down debt through regular principal payments made with the monthly mortgage payment. Permanent financing for commercial real estate and multifamily typically amortizes on a 30-year schedule, meaning the debt would be fully paid off if principal and interest payments were made over the course of 30 years. This rarely happens as most permanent financing has a 10-year term, leaving due a balloon payment of the remaining loan balance after 10 years. Bridge loans typically include no amortization and have interest-only payments for the full term of the loan, which is typically two to three years.

Amortization

This drives all expenses except those modeled discretely. It starts from day 1 vs at stabilization for rent appreciation.

Annual expense increase

Keep it to inflation and after stabilization to ensure the deal pencils without this sensitive compounding assumption

Annual rent increase

- Real estate ventures typically include an AM fee. Usually assessed on Effective Gross Revenue; standard fee is 1% to 2%, depending on the Property Management Fee and size of property. •

Asset Management Fee

is the process of purchasing a property subject to the existing loan on the property. This input should be left as "No" unless you want to model an assumption. To model an assumption, find current loan details, including outstanding loan balance, interest rate, amortization, start date, maturity date, interest-only period, and fees associated with assuming the loan. Instead of "No", input the current loan balance for the loan.

Assumption? - A loan assumption

- This line item is for uncollectable rent also known as write-offs. T12s often have a delinquent rent line item and a recovered delinquent rent. If this is the case, be sure to sum both into a net bad debt number. For whatever reason, recovered rent sometimes shows up separately under Other Income. Stabilized assumption usually 0.5% - 2.5%

Bad Debt

- Also called operating capital, this is capital put into the property's operating account or owner account and used to run the business but should also represent some cushion of reserves. There are always unanticipated costs associated with purchase and property takeover and the first few months may be more difficult than anticipated. Having ample reserves that can be depleted and then replenished over the first few months is a wise protocol. As a general rule, we reserve two to three months' worth of operating expenses (here in the screenshot we have two months of operating expenses).

Cash Reserves

- Input the number of units to be renovated as part of capital expenditures ("capex").

# of Units to Rehab

- This is a standard closing cost paid by the deal to the sponsor or general partner putting together the investment. In our model, the percentage is based on the purchase price but in practice, the fee can be based on total capitalization, purchase price, total equity, a flat fee, or nonexistent.

Acquisition Fee

- Office-related expenses needed to run the property such as the cost of background checks, printer paper, property management software like ResMan, and phones.

Administrative

- Closings costs are costs associated with purchasing property such as third-party reports (environmental report, property condition report, and appraisal), inspections, title fees, and legal fees. We typically use 3% of the purchase price as a preliminary approximation of closing costs. For the modeling purposes, we include property tax and insurance escrows as closing costs even though they are technically reserves and are refunded upon refinance or sale. Lenders typically require the full year's insurance premium to be paid at closing and also require a certain percentage of the anticipated property tax bill to be escrowed based on an escrow analysis. We choose to treat these escrows as costs to keep things simple while also being more conservative.

Closing Costs

1-3% dependent on size and type of property sold

Commission/Title/Legal (exit)

- This line item is for any discounts, concessions, and non-revenue generating units such as units used for storage or down units (units in inoperable condition).

Concessions/Non-Rev

Discounts, free spaces for employees, etc.

Concessions/Non-Rev

- Work done at the property that is not done in-house (this excludes contracted work related to "make readies") such as landscaping, snow removal, and pest control.

Contract Services

is a provision in a contract that voids a bond or loan on a balance sheet when the borrower sets aside cash or bonds sufficient enough to service the debt.

Defeasance

- This input should only be changed if you're looking to model a refinance in your underwriting. However, incorporating a refinance in your underwriting is not good practice - do this only if absolutely necessary. To model a refi after 36 months of ownership, for example, you would change the Duration to 36 months so the new loan starts on month 37.

Duration (finance)

Economic vacancy calculates vacancy as a percentage of lost income not just number of units.

Economic Vacancy

- Here we assume $400,000 or $2,000/unit for exterior renovations. This could include roofing, siding, pavement, plumbing, exterior lighting, fencing, and adding/improving amenities to the property.

Exterior Budget

Financing Fees - Loans often include an upfront fee paid at closing, called a financing fee. Additional fees here include a mortgage broker fee. Lenders typically charge a 0.5% to 1% financing fee and mortgage brokers charge between 0.5% to 1%.

Financing Fees

- Franchise Taxes are not found everywhere, but they are a reality for Texas multifamily with revenue greater than $1,110,000. Since most of the properties we underwrite are in Texas, Franchise Tax is standard in our underwriting, but it should of course be removed or adjusted when underwriting properties in other states. As you can see, there is some art to even

Franchise Taxes

Notice that Vacancy Loss here differs from the T12 figure - we use a separate Going In Vacancy Rate input that lets us adjust the starting vacancy rate. There is often a spike in vacancy at takeover due to the likely NTVs, evictions, and skips that we will be dealing with as we start working to improve the property. Some other metrics such as Bad Debt could also increase for the first few months of stabilization. However, for simplicity, we assume Bad Debt begins at the T12 level and trends towards the stabilized Bad Debt assumption over the course of the Stabilization Period. Slightly overstating Going-in Vacancy can help account for some of these other potential losses early on in the investment.

Going in Vacancy Rate (Stabilization)

- As previously discussed, this input represents projected month one vacancy rate which will then escalate linearly up to the Stabilized Vacancy Rate over months of the Stabilization Period.

Going-in Vacancy Rate

Model accepts 3-10 yrs, use a consistent 5yrs for value add deals so you can compare

Hold Time

- Loans often have an interest-only period for the first one to five years of the loan. As mentioned before, bridge loans are interest-only for the entire term of the loan. This input allows you to specify how many years the loan is interest-only for. In our example, only interest is paid on the loan for the first year and the payments in the subsequent nine years include principal and interest payments.

IO Period

then it's possible to estimate Gross Potential Rent using the Rent Roll. The Rent Roll should show market rents and lease rents; multiply the difference by 12 to annualize Loss to Lease in the Rent Roll. Vacancy Rate can also be estimated based on the Rent Roll's Physical Vacancy.

If the T12 for the property you are underwriting does not have a Gross Potential Rent line item, Loss to Lease, or even Vacancy Rate, and instead just shows a total collected rent number,

Gross Potential Rent never happens and your model should appropriately consider income loss line items such as loss to lease, vacancy, non-revenue units, concessions, employee discounts, and write-offs. Pro forma rents are a very sensitive input, meaning they have a major impact on the results of your underwriting, especially for a value-add investment. A value-add deal can go from great to terrible just by changing pro forma rents by $50.

Income Loss Items

- Property insurance, general liability, and umbrella insurance. Some properties or lenders may require additional insurance such as flood insurance.

Insurance

- Self-explanatory. However, if you are using floating rate debt, choose "LIBOR Plus" rather than a fixed interest rate. In the cash flow "Pro Forma" tab there is a LIBOR forward curve which can be updated or changed to SOFR (or whatever becomes the prevailing short-term interest rate benchmark index). This will allow you to project floating rate debt as well as stress test interest rates if you would like to input a +1 standard deviation LIBOR or SOFR forward curve.

Interest Rate (finance)

- For properties that have very little to negative going-in cash flow, the lender will hold back a reserve to make debt service payments. When we underwrite to negative year one cash flows, we will usually input an interest reserve that is 150% to 200% of the negative cash flows. Then we will input an interest reserve draw in the Pro Forma to offset the negative cash flows.

Interest Reserve

- Assuming you have budgeted interior renovations or repairs, you can input the average cost per unit for these capital expenditures. This number is multiplied by the number below it (# of Units to Rehab) to calculate the total interior budget. In the example above, we assume a fairly typical renovation for B/C class apartments in Texas of $5,000/unit for all 200 units.

Interior Cost Per Door

- This is the where you specify how much leverage the loan will be (typically between 70 and 80%).

LTC or LTV

Loans are often measured on a loan-to-value basis, usually meaning loan amount divided by purchase price. However, many lenders allow an increase of the loan amount by measuring their LTV based on eligible costs including the purchase price plus capital expenditures and even closing costs. You can change this input from "Yes" to "No" to toggle whether you want the loan's proceeds to be based on loan-to-cost or loan-to-value (just purchase price).

Loan to Cost?

Loss to lease refers to any difference between market rents and lease rents in a property's rent roll. Loss to lease can be attributed to cyclicality in the leasing season or old leases which have yet to renew and capitalize on the market rent growth that has occurred.

Loss to Lease

Market - actual (in-place) rents: Typically assume 2% or even 0% if there was a gain to lease to start (higher actual vs market)

Loss to Lease (stabilized)

difference between market rents and lease rents. This is often found on the property's T12 but is only accurate/relevant if the T12's Gross Potential Rent is equal to the one that was generated by your inputted Unit Mix from before. Adjust T12 Loss to Lease input to reflect the Net Potential Rent (Gross Potential Rent minus Loss to Lease) in the T12, i.e. Model Loss To Lease equals T12 Net Potential Rent minus Model GPR.

Loss to Lease on T12 vs model

- This line item refers to a 3rd party property management fee. Some properties are "self-managed", meaning the owner of the property manages the property him or herself in lieu of hiring a management company. As you can see in our above example of the Operating Expense table of inputs, the T12 Management Fee is already calculated based on market rate (3% of Effective Gross Income in our example). This a more accurate understanding of the property's current expense load. Just because an owner can get by without showing a property management fee on their own P&L doesn't mean that we (the market) should expect such low expenses and thus be willing to pay an inflated value based on cashflow that we would likely not get.

Management Fee

should be reflective of the rent level currently being achieved on the property (less any modest loss to lease).

Market Rent

be cognizant of the validity of market rents since those can be set by the current owner/manager of the property to any level they desire and simply offset it by loss to lease. Rarely should you accept market rents at face value. There are plenty of times when I've underwritten a deal and threw out the market rents from the rent roll and set my own market rents for the property because the loss to lease was so large. I'd rather more accurately reflect lease rents in my market rents than underwrite a large in-place loss to lease.

Market Rent Lookouts!

- Sometimes found in Administrative, includes listing on Apartments.com, resident retention events such as a pizza renewal party, brochures, and resident referral fees.

Marketing

- This can be for HOA dues or other deal specific costs that are best broken out from other expense groups.

Other (OPEX)

catch-all line item for all income other than rents and RUBS such as application fees, late fees, reserved parking, etc. Keep an eye out for irregularities or large one-time payments that may need to be excluded to more accurately reflect recurring Other Income.

Other income

- any expense related to on-site staff, including health insurance, worker's compensation, temporary staffing and bonuses, but should not include a 3rd party property management fee.

Payroll

a percentage of physically occupied units irrespective of the rents for each unit. (% of units vacant)

Physical Vacancy

- The assessed value for property tax purposes can often vary substantially from the purchase price. This is why it is very important to consult a property tax advisor. In our example deal here, we have a purchase price of $10,000,000 and are assuming an 85% assessment ratio (assessed value divided by purchase price), resulting in an assessed value of $8,500,000.

Projected Assessed Value

- We previously discussed the 3rd party property management fee in the Operating Expenses section. We input that fee here to account for the ongoing cost of management throughout the life of the underwriting. This fee is also assessed on Effective Gross Income.

Property Management Fee

You may need to assume the same percent increase as your revenue increase (NOI / cap)

Property Tax Increase

- Also known as millage rate, this can be found on the county assessor's website.

Property Tax Rate

As with management fee, T12 and Stabilized Property Tax columns are both pre-calculated using the projected forward number. Current tax can be recorded in the Notes area to the right. Since property taxes are usually reassessed on sale, using existing property taxes would overestimate achievable cashflow when calculating the "going in" cap rate. As a buyer, it doesn't help us to know what the seller was paying for property taxes (except as a data point in determining pro forma assessed value). Property taxes vary and have a major impact on terminal value - consult a local property tax expert for the best guidance.

Property Taxes

(ratio utility billing system) utility billback system for buildings without separate utilities. E.g., water, sewer, electric, and trash.

RUBS

if Going-In Vacancy is 50%, then units renovated per month can be more aggressive, and thus Stabilization Months input can be lower. Conversely, if the plan is to maintain 95% occupancy while programmatically renovating all 200 units, that will take a lot longer. One of the biggest mistakes that people make is to be overly aggressive on expected stabilization timeline. We all know that projects, especially in construction, take longer than anticipated, and there are always unforeseen bumps in the road. Best to be conservative and err on the side of a longer stabilization period.

Renovation Timing Assumption Tips

- Things break and tenants complain - best to be proactive and have a good preventative maintenance program, and respond to work orders as quickly as possible. Expenses cost money, of course, but doing this right pays off in tenant satisfaction and retention.

Repairs & Maintenance

- These are lender-escrowed reserves usually between $200 to $450/unit/year, intended to be drawn down for recurring capital expenditures such as appliance or flooring replacements. Our model has T12 and Stabilized Replacement Reserves set at $300/unit/year, which is what we typically use for preliminary underwriting. Again, we are less concerned with what the current owner is reserving per the terms of his or her loan agreement. What matters is what we will actually see - current (T12) income level adjusted by our anticipated replacement reserves. It is also worth noting that Replacement Reserves are here in Operating Expenses to begin with. You sometimes won't see Replacement Reserves "above the line", meaning included in the NOI calculation on profit and loss statements. However, for underwriting purposes, the proper method is to include Replacement Reserves in calculated NOI rather than pushing it "below the line" in the cash flow statement, or as a capital item after NOI is calculated. Keeping Reserves above the line reduces NOI and thus conservatively dampens asset valuation. Furthermore, lenders calculate NOI this way as well, so keeping consistent with their process helps when looking at underwriting to determine appropriate loan assumptions.

Replacement Reserves

Lender required amount, he assumes $300 for B/C multifamilies.

Reserves per unit (stabilized)

pro forma rents (in this case it is $850) are used to calculate stabilized Gross Potential Rent. Gross Potential Rent is the total possible rents that would be collected if all units are occupied with no loss to lease or delinquency. If that were true in our example, the property should collect 100 x $850 x 12 = $1,020,000 in gross revenue per year.

Stabilized Gross Potential Rent

"strike" price - the price expectation from the broker

Strike Price

trailing 12-month profit and loss statement. A year is enough time to smooth out minor irregularities/noise in month-by-month financials. If there is a clear trend in recent months, annualized T3 can be used (= 4 * Final 3 months of T12) for revenue only (for expenses, use T12 - expenses vary seasonally, are not always billed monthly, and are less consistent overall versus income). If using T12, use T12 for all revenue items; if using T3, use T3 for all revenue items.

T12

AKA exit cap rate or terminal cape rate: Projected T12 NOI at sale / terminal cap rate = sales price

Terminal Cap Rate

Consistency is most important - always keeping the same line items in the same categories across different properties you underwrite, to allow like-for-like comparison. The "Underwriting Notes" section towards the end of Broker OMs are also a helpful spot to see where particular items go in typical industry practice, though the specific values projected in Broker OMs may be on the sunny side. Having covered all line items on both the income and expense side, we can now move on to operating assumptions.

Tips for Income and Expense Lines

- Some states or counties have a transfer tax that is paid by the buyer, seller or both. This is based on the purchase price.

Transfer Tax

- Also known as Make Ready, refers to the cost of preparing vacant units for new tenants. This can include carpet cleaning or replacement, paint, new appliances, and other unit repairs.

Turnover

- What the "house" pays varies by property, but look for electric, water, sewer, trash, and cable. Pay attention to the water bill and the common area electric bill as these numbers can present opportunities for cost savings on older/unrenovated properties.

Utilities

Revenue lost from vacant units. If a property's T12 has a story it can be better to use T3 vacancy to more accurately reflect current performance.

Vacancy Rate

The minimum allowed by agency lenders is 5% for underwriting, but he typically uses 7-10% based on market comps close by.

Vacancy Rate

google the name and/or address of the property with the word "crime" or "shooting", or try searching the property name/address in Google News. Additionally, you can review crime related information about the property's location on www.city-data.com, www.spotcrime.com, www.crimereports.com, and www.areavibes.com.

Where to find crime info about property and area

is a kind of prepayment fee that borrowers pay to lenders, or bond issuers to investors, to compensate for the loss of interest resulting from the prepayment of a loan or the calling in of a bond. (Investopedia)

Yield maintenance

• The address of the property • A trailing 12-month financial statement (profit and loss statement). • A rent roll showing unit type, rent, and additional charges for each unit . • A trusted underwriting model in Microsoft Excel. Go to www.lonestarcapgroup.com to get your free copy now. • Optional: Brokers will typically furnish an Offering Memorandum, which assembles a lot of helpful information, including a pro forma and business plan. Projections will often be too simplistic or aggressive to accept at face value, but are helpful presentations of a strong upside case. • Optional: Data reports such as Yardi Matrix, CoStar, or Apartment Data Services

required materials and information needed to fully underwrite a multifamily property

In our model, we wait until the pro forma rents and assumptions are achieved before rents start escalating at the annual rent growth assumption (usually 2% to match inflation). Many models run the annual rent growth throughout the entire duration of the model, starting from month one. This will of course make the deal look better than the other method. Neither way is necessarily correct, but be aware which method your model uses.

whether to begin the annual rent escalator during or after the stabilization period.