A Step-by-Step Guide to Underwriting a Multifamily Deal and Deciding Whether to Submit an Offer
Underwriting a multifamily deal is one of the most critical processes in real estate investment. It involves evaluating the financial viability of a property to determine whether it’s worth pursuing and, ultimately, making an informed decision about whether to submit an offer. A thorough underwriting process helps ensure that your assumptions align with market conditions, reduces the risk of overpaying, and ensures that the property will generate the desired returns.
Here’s a step-by-step guide to underwriting a multifamily deal and determining whether to move forward with submitting an offer.
1. Gather and Review Preliminary Information
The first step in the underwriting process is collecting all relevant information about the property. This includes:
Offering Memorandum (OM): This document, typically provided by the seller or broker, gives an overview of the property, including the rent roll, property condition, location, amenities, and more.
Rent Roll: This provides detailed information about current tenants, including lease terms, rent amounts, and any vacancies.
T-12 Financial Statement: Also known as the trailing twelve months (T-12), this document outlines the property’s income and expenses over the past year.
Market Comparables (Comps): Research comparable properties in the area to understand the local market conditions, including rent rates, occupancy levels, and cap rates.
This preliminary data serves as the foundation for the underwriting process, allowing you to assess the property's current performance and future potential.
2. Analyze the Market
Understanding the local market is crucial to accurately underwriting a multifamily deal. Market analysis should include:
Occupancy Rates: Look at the average occupancy rates for similar properties in the area. If the subject property has a lower occupancy rate, investigate why.
Rent Growth: Evaluate the historical and projected rent growth in the market. Strong rent growth can indicate a healthy, thriving market, while stagnant or declining rent growth could signal challenges.
Supply and Demand: Assess the supply and demand for rental housing in the area. Are there new developments that could impact occupancy or rent rates? Are there economic drivers (e.g., job growth, population increases) that suggest demand will remain strong?
A solid understanding of the local market will allow you to make realistic assumptions when projecting rental income and potential value-add opportunities.
3. Estimate Potential Income
With the rent roll and market data in hand, you can begin estimating the potential income for the property. This includes:
Current Rental Income: Based on the existing rent roll, calculate the property’s current gross rental income. Adjust for any known vacancies and concessions.
Market Rents: Compare the current rents to market rents for comparable properties. If there’s a significant gap between the two, this could indicate an opportunity for rental growth, especially if the property is under-rented.
Other Income: Consider other sources of income, such as fees for parking, laundry, pet rent, or utility reimbursements. These ancillary income streams can add significant value to a deal.
Once you’ve estimated the gross income, account for vacancy rates and credit loss to arrive at the property’s effective gross income (EGI).
4. Estimate Operating Expenses
Next, you’ll need to estimate the property’s operating expenses. The T-12 financials will give you a snapshot of the current operating expenses, but you’ll need to assess whether those expenses are reasonable and in line with market standards. Common expense categories include:
Property Management Fees: This is typically a percentage of the EGI and varies based on the property’s size and the local market.
Repairs and Maintenance: Consider the age and condition of the property when estimating repair and maintenance costs.
Utilities: Include all utility costs, especially if some or all utilities are covered by the landlord.
Taxes and Insurance: Property taxes and insurance premiums vary by location and should be based on local rates.
Capital Expenditures (CapEx): Include a reserve for future capital expenditures, such as roof replacement, HVAC upgrades, or major renovations.
Once you’ve gathered and reviewed the expense data, subtract it from the EGI to determine the property’s net operating income (NOI).
5. Assess Debt and Financing Options
The next step in underwriting is determining the financing structure for the deal. Financing terms will have a significant impact on your overall returns, so it’s important to carefully evaluate your options. Consider the following:
Loan Amount: How much leverage will you use? Most multifamily deals are financed with a combination of equity and debt, with loan-to-value (LTV) ratios typically ranging from 65% to 80%.
Interest Rate: Determine the prevailing interest rates for the type of loan you’re seeking. Locking in a low interest rate can greatly improve your cash flow.
Amortization and Loan Term: Consider the loan’s amortization period and term. A longer amortization period results in lower monthly payments, but a shorter term may reduce the total interest paid over time.
Once you’ve identified potential loan terms, calculate the annual debt service (loan payments) to understand how it will affect your cash flow.
6. Determine Cash Flow and Returns
With the NOI and debt service figures in hand, you can now calculate the property’s projected cash flow:
Cash Flow Before Tax: Subtract the annual debt service from the NOI to arrive at the property’s cash flow before taxes. This figure gives you a clear understanding of how much income the property will generate after covering operating expenses and debt payments.
Next, calculate key return metrics to assess the deal’s attractiveness:
Cash-on-Cash Return: This measures the property’s annual cash flow relative to the amount of equity invested. It’s a key metric for investors looking to generate ongoing cash flow from their investment.
Formula: Cash Flow Before Tax / Total Equity Invested
Internal Rate of Return (IRR): IRR estimates the overall profitability of the investment, taking into account both the cash flow and the potential sale proceeds at the end of the investment period.
Cap Rate: The cap rate is the ratio of the NOI to the property’s purchase price and is often used to compare the performance of different investment properties.
7. Stress-Test the Deal
To ensure that the deal can withstand market fluctuations, it’s essential to perform a stress test. Adjust key variables (like occupancy rates, rent growth, and operating expenses) to see how changes impact the property’s cash flow and returns.
For example:
What happens if the occupancy rate drops by 5%?
How does the deal perform if rent growth is lower than expected?
What if operating expenses increase faster than projected?
A stress test helps you understand the downside risks of the investment and ensures that your assumptions are conservative.
8. Review Comparable Sales and Pricing
Before making an offer, review recent sales of comparable properties in the area. This will give you a sense of the market value and help you determine whether the asking price is fair. Pay close attention to the cap rates of recently sold properties, as these can serve as a benchmark for your underwriting.
9. Decide Whether to Submit an Offer
After completing the underwriting process, you should have a clear understanding of the property’s financial performance, potential risks, and expected returns. Now, it’s time to decide whether to move forward with submitting an offer. Ask yourself:
Does the property meet my investment criteria? Based on your target returns, market analysis, and financing options, does the deal align with your goals?
Is the asking price reasonable? If the property is priced higher than your underwriting suggests, is there room to negotiate?
Am I comfortable with the risks? Are the market conditions, property condition, and assumptions realistic?
If the answers to these questions are positive, you’re ready to prepare and submit an offer. If not, it may be best to walk away or continue negotiations.
Underwriting a multifamily deal requires a methodical and detailed approach. By carefully analyzing income, expenses, market conditions, and financing options, you can make informed decisions and avoid overpaying for a property. Ultimately, thorough underwriting provides the confidence needed to determine whether submitting an offer is the right move for your investment strategy.
