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Apartment Financial Underwriting - Part 1 of a 2 Part Series

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In a few recent conversations with different folks, it has come up how they are calculating financial performance on multi-family projects. I feel the need to write an article on this, since in many of these conversations folks were mixing the financial ratios up between rental and for-sale project types. Having clarity when speaking about real estate financial analysis goes to the identity of the person who is speaking the ratios. I am grounded that in all cases, investors, lenders, and land sellers will hold the person speaking in a different regard if they are accurate in their assessments of financial performance of multi-family real estate projects.

Generally, in the multi-family development and institutional level value-add markets, we use the following ratios:


Internal Rate of Return

Equity Multiple

Cash on Cash Equity Returns (ONLY on stabilized operations cash flow)

In this Part 1 of a 2-part article, we'll delineate how to model an apartment project cashflows. Part 2 will delineate the calculation of the ratios.

Proforma Analysis

The basics of a financial model or “proforma” for a development project:

Income and Expense

Construction Period Cash Flow

Internal Rate of Return

Income and Expense Analysis

On apartment deal underwriting or financial analysis, we’ll first break it down very simply for you to gain an understanding of the fundamental components of income and expense analysis for an income producing property. Once you get that, you’ll be able to use it daily and effectively, then make it more complex as you get more seasoned in your underwriting skills. But as you underwrite deals, you will always be able to hold the basic structure in your mind, then work the details on each deal in a spreadsheet that you can easily build yourself.

Basic rental income and expense summary:

Rental Income from all units, also called Gross Income

Less Vacancy Factor (typically 5%)

Equals Gross Adjusted or Effective Gross Income (has various names, but this is what I call it)

Less Operating Expenses and Reserves

Equals Net Operating Income

This fundamental formula applies to all income producing properties, apartments, office, retail, self-storage, etc. Each component may have a different name, or be subject to slightly different allocation of cost (triple net office has the tenant pay most of the operating expenses and property taxes), but the bottom line number that we care about is Net Operating Income or NOI.

When you hear people talk about NOI, you'll know how that is defined (formula above). What it means is the amount of money or cash flow that is available to make the loan payment, and the amount of cash flow that can be used to value the property in a sale or refinance. Using this formula, combined with cap rates (see below), you can underwrite all types of income property investments.

Construction Cash Flow Analysis

This is the flow of expenditures during the construction period. This cash flow schedule is particular to a development project, as you will need to calculate the interest on borrowed funds and the preferred return paid on equity as a function of your construction period expenditures. A normal investment property doesn’t have major expenditures beyond the purchase, whereas a ground up development project has all the necessary expenditures to complete the units and lease them up.

The construction cash flow is nothing more than a spread of each construction cost line item over the specific time period of your construction schedule.

Generally, the time period of construction is derived during your initial due diligence and provided to you by your in-house construction team, or a third party general contractor. A rule of thumb is to always allow more time than you think to build. Unless, you are a production home builder constructing the same unit plan over and over again, a custom or one-off design can only be roughly assessed for total construction schedule. You always need to leave yourself extra time in your schedule. This can be for the normal friction of time loss due to city inspection delays, weather delays, RFI’s, and owner initiated plan changes. On the opposite end of the spectrum, you could assume significantly longer time periods for construction than your team indicates, but this will erode your financial returns due to overly conservative (meaning higher) amounts of interest carry and pref returns on equity. So you need to strike a balance, with some “cushion” to protect against normal friction.

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Assessments of Value - Using Capitalization Rates

Once you have the NOI, you can then value the property using the Capitalization Rate or Cap Rate. These are market based assessments of value, that can then be used to underwrite your project. On a development deal (and on all "value add" deals) we have two cap rates:

1. Development cap rate, which is the NOI divided by the cost of the project, or NOI/Cost. When we speak, we say "NOI to Cost". This is what is used when running proformas to determine value at sale or refinance once the project is built out, leased up and producing income (or projecting these values during initial underwriting). This ratios is also used as a comparison tool for the market or what other development projects are producing with which we compete. You might say: "we are building to a 6% NOI/Cost, what are you building to?" or "the equity investor says they want a 7% minimum NOI/Cost, do our numbers meet that criteria?"

When an equity investor is making an assessment of your project, they will ask what is your NOI/Cost ratio (i.e. development cap rate). Example: Our Cedar project is producing somewhere over a 7.5% NOI/Cost. If other developers' project is producing a 7% ratio, our project is producing a superior offer or more NOI to each dollar of cost spent to produce that NOI.

2. Exit cap rate. This is the cap rate in the market upon sale of the project, that determines the value of project upon sale or refinance. This is derived by taking the NOI produced by your project and divide by the going cap rate gained from market research.


"Broker says that our project should sell at a 4.5% cap rate, our NOI is $100,000, so our value should $2.2M at sale" ($100,000 divided by .045 = $2,222,222).

Another way is that you actually sell at a price derived from a bidding process that you produce in the market, and then divide the sale price by the NOI to get the cap rate at sale: "Our sale price was $8.69M, our NOI was $400k, so our cap rate at sale was 4.6% ($8,690,000 divided by $400,000 = .046 or 4.6% cap rate)

The difference between the development cap rate (NOI/Cost) and the Exit Cap Rate is your development profit. Let's say you can develop to a 7.5% NOI/Cost and sell at a 4.5%. Your spread is 3%, which is the value you've produced as the developer. You may more simply say total sales prices less total project costs is your development profits, but I want you to see where we get the value for the sale or refinance first, then you can use that to subtract and calculate the profit. Of course, the market always dictates, so the more buyers you have bidding for your project the better the price you can demand. We always want to create an auction for our project when able. But the market sometimes goes against you, so you may not get an auction, or worst case, in a down market you may sell at an actual auction. But the main purpose of delineating cap rates here, is to understand the meaning of NOI in the creation and assessment of value for an income producing project.

Remember: when speaking with sophisticated investors, knowledge of these ratios and the ability to work them and speak them, will set you apart from the rest of the market.

Here is a sample proforma:

Proforma Income and Expense Summary

Apartment Financial Underwriting

Construction Cash Flow Analysis

Apartment Financial Underwriting1

Internal Rate of Return Analysis

Apartment Financial Underwriting2

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