Many believe that multifamily is the easiest of all asset classes to underwrite. While this may be true, multifamily properties have their own set of unique challenges. Follow these 6 multifamily underwriting essentials to stay on the right track.
The direct capitalization approach is the most common method used to value a multifamily property. Simply put, divide the net operating income (NOI) by the capitalization rate (cap rate) to find market value. However, finding the real NOI and the potential NOI may be difficult, and cap rates can vary widely depending on a variety of factors.
Essential 1: Rent Roll
In all cases, the first multifamily underwriting essential is a current rent roll.
Most lenders require a current rent roll that is within 30 to 60 days of the closing. Your rent roll spreadsheet should contain the following information: the building number (if there are multiple buildings), unit number, unit type (i.e. 1BR/1BA) and unit style (if there are multiple styles).
You must also include:
- Tenant name
- Square footage
- Move-in date
- Lease commencement date,
- Lease expiration date
- rental rate
- concessions (if any)
- miscellaneous charges
Once you have all of this information, calculate the average in-place rent. In some cases, the rent roll will show actual rent and market rent. Test the market rent by looking at the most recent leases signed in each unit type (factoring in concessions) and comparable rentals in the market.
Once you determine the supportable market rent, you can calculate how much below or above market the in-place rents are. This will tell you if you can raise rents.
Calculate your gross potential rents by adding the market rents from vacant units to the in-place rent for the occupied ones.
Essential 2: Historical Operating Statements
Next, ask for the historical operating statements on the property. Request statements from a minimum of three years so that any variances can be identified.
Analyze vacancy, concessions, and loss to lease (if applicable) to determine appropriate percentages for year one. Isolate and explain other income for year one.
For example, if the property charges for parking and you know the fees and number of spaces, make sure that the monthly and annual parking figures on the operating statement make sense. They should closely match the figures on the rent roll, and be explained easily by the seller.
The same goes for any utility reimbursements (RUBs), laundry income, pet fees, and the like.
Fixed and Variable Operating Expenses
Operating expenses are categorized as fixed or variable expenses.
Fixed expenses are those that do not fluctuate based on occupancy or management style. This applies to real estate taxes, insurance, and common area utilities.
Variable expenses include repairs and maintenance, turnover expenses, grounds maintenance (landscaping and snow plowing), payroll, management fees, administrative, marketing, and advertising expenses. These variable expenses may vary depending on the management style, occupancy, or tenant profile.
Essential 3: Vendor Contracts
Obtain copies of all vendor contracts, relevant for analyzing variable operating expenses.
While most contracts are cancellable upon 30 days of notice, some may require termination fees if canceled early.
Also, the amounts stated in the agreement should reconcile with historical expenses on the operating statement. If they don’t, ask the seller why.
Essential 4: Repairs and Maintenance
Analyze repairs and maintenance expenses in detail, the fourth multifamily underwriting essential.
Ensure the seller explains any large “one-time” expenses since they could be non-recurring.
In a value-add transaction, where capital expenditures are planned, it may be justifiable to reduce some of these repairs and maintenance expenses. After all, if you replace sidewalks, boilers or roofs, the cost of maintaining them will be minimal during and after the work is completed, until there is wear and tear.
Essential 5: Payroll
Request a breakdown of the property’s payroll. Some owners prefer doing a lot of the maintenance in-house as opposed to contracting with outside vendors, so it is important to understand the relationship between payroll and other expenses such as repairs and maintenance, turnover expenses, and grounds maintenance.
Heavier payroll enables a landlord to lower these expenses, so understanding what each employee on the payroll does is extremely important in order to understand this relationship.
Higher payroll may also justify a lower management fee.
Essential 6: Turnover
Turnover is another important operating expense to understand, the sixth multifamily underwriting essential.
At a property where the owner is not systematically renovating apartment interiors, this is the expense to “turn” a unit or make it ready (sometimes called “make ready expense”) for the next tenant. This includes cleaning, painting, and other minor repairs.
The seller should include these expenses as an operating expense and not moved below the line to capital improvements.
Calculate the average cost per unit by taking the annual expense and dividing it by the number of tenants that moved in that year. For this reason, ask for the number of move-ins over the past three years.
The number of move-ins divided by the total number of units equals the annual turnover percentage, which can range from less than 5% in rent-regulated properties to over 50% in areas where there are a lot of short-term rentals and transient population.
Other Expense Considerations
In addition to the 6 multifamily underwriting essentials, here are some other things you want to keep in mind:
- Study fixed expenses such as real estate taxes, insurance, and utilities.
- Review all copies of the tax bills and investigate the risk of re-assessment.
- Visit the assessor’s website or call the assessor to understand the methodology, tax calendar, and applicable mill rates. In a sale transaction, there may be a risk of the sale price driving up the assessed value.
- Review the insurance declaration and the invoices to ensure adequate coverage is in place.
- Total all utility bills and match them against the operating statement.
“The devil is in the details”
Underwriting multifamily properties is all in the details. Getting the information may be challenging, but the more you are able to get, the better equipped you will be to identify risks and to support your final conclusions. Don't forget these 6 multifamily underwriting essentials on your next underwriting project.
Contributor: Patrick Bisceglia
Patrick Bisceglia has over 30 years of commercial real estate experience. His highly diverse background includes investment sales, leasing, asset management and capital markets. As an investment sales broker at Rockwood Realty Associates, CB Richard Ellis, Grubb & Ellis and Transwestern he has been involved in the sale of over $4.0 billion in real estate including a number of high-profile transactions.
Mr. Bisceglia also has extensive asset management experience and has managed over 4,000 multifamily units and 500,000 SF of office and retail properties for both institutional and private clients. He was the asset manager and disposition agent for the creditors committee on a 120-asset portfolio of distressed loans and REO owned by lender in Chapter 11 and Chapter 7 bankruptcy proceedings.