First, let’s define some key terms:

Limited Partner (LP): passive investor with limited control rights

General Partner (GP): active partnership with control rights who organize and offer the investment.

Promote: Share of profits allocated to the GP, usually after a preferred return is paid to LPs

Preferred Return: the return that LPs are entitled to before GPs can earn their promote

Cash on Cash Return: Return metric that measure return on capital (Cash Flow / Capital Invested)

IRR: Internal rate of return, a sophisticated return metric that provides the time value of money-adjusted return of an entire project (capital outlay, cash flow, and liquidity events) – must include return of capital.

Waterfall: type of profit-sharing model that includes tiers or hurdles in order to incentivize GP performance.

Hurdle: the return threshold that LP cash flows must achieve to advance to the next tier in an equity waterfall structure.

You can see that both structures feature a preferred return, but it is important to understand that they can have completely different implications on LP returns due to the hurdle type. Let’s start with the more simple structure: cash on cash hurdle + Promote. In this example, LPs are entitled to an 8% cash-on-cash (CoC) return before any profit splits take place. In other words, GPs do not get compensated (by earning their promote) until LPs earn 8% on their capital. After this hurdle is met, GPs are entitled to their promote, which is 30% in this example.

In the IRR Hurdle Waterfall structure, LPs are entitled to a certain IRR before GPs can earn their promote. In this example, the IRR hurdle implies that LPs are entitled to a 7% IRR. Note: the IRR hurdle entitles LPs to not only a time value of money-adjusted 7% return ON their capital but a full return OF capital before any profit splits take place. Further, in this example, there is a waterfall aspect present. Here are the implications of the waterfall terms pictured in the above screenshot in simple terms:

Tier 1: LPs are entitled to a 7% IRR preferred return.

Tier 2: Thereafter, profits are split 80% to the LP and 20% to the GP until LPs earn a 15% IRR.

Tier 3: Thereafter, profits are split 60% to the LP and 40% to the GP.

I hope this helped demystify the profit-sharing models most common in commercial real estate syndication.

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The post Understanding Equity Structure: Common Profit-Splits first appeared on Horizonten Properties.

Pitfall 1: Inaccurate Income Projections

One of the first pitfalls to avoid is overestimating rental income. Inaccurate income projections can have a significant impact on cash flow and overall profitability. To address this, conduct thorough market research, analyze historical data, and consider factors such as potential vacancies and economic changes. This approach will help you create more accurate income projections and make informed decisions.

Pitfall 2: Underestimating Expenses

Underestimating expenses can erode profitability and lead to financial challenges. It is crucial to carefully assess various expense categories, including maintenance, property management, utilities, etc. By accurately estimating costs through industry benchmarks, expert opinions, and comprehensive budgeting, you can ensure that expenses are adequately accounted for.

Note: It is very important to understand that pitfalls 1 and 2 deal directly with a property’s NOI projection, which translates to exit valuation – one of the most sensitive factors when calculating project-level returns. This means any slight miscalculation here will lead to an outsized impact on project-level return calculations, potentially leading to heavily misrepresented deals and ultimately unhappy investors.

Pitfall 3: Poor Due Diligence

Thorough due diligence is key to uncovering potential risks and hidden issues. Neglecting this step can have severe consequences. It is essential to inspect the physical condition of the property, review all relevant documentation, and assess market demand and competition. By conducting comprehensive due diligence, you will minimize surprises and make informed investment decisions.

Pitfall 4: Inadequate Risk Assessment

Inadequate risk assessment is a pitfall that can significantly impact multifamily underwriting. To mitigate risks effectively, analyze market trends, tenant demographics, economic indicators, and other factors that influence risk levels. By adopting a comprehensive risk assessment approach, you can make informed decisions and better protect your investment.

Pitfall 5: Neglecting Regulatory and Legal Considerations

Disregarding regulatory compliance and legal requirements is a pitfall that can lead to complications and legal consequences. It is crucial to understand and adhere to zoning regulations, obtain necessary permits, address environmental issues, and comply with tenant laws. By giving due consideration to regulatory and legal factors, you can avoid unnecessary setbacks.

How to Avoid Pitfalls: To navigate these common underwriting pitfalls successfully, here are some best practices:

• Conduct thorough financial analysis, including income and expense evaluations.
• Leverage industry tools, databases, and technology to enhance accuracy and efficiency.
• Seek expert advice from professionals such as appraisers, inspectors, and attorneys.
• Stay current on market trends, industry developments, and regulatory changes through continuous self-education and networking.

Avoiding common underwriting pitfalls is vital for achieving success and profitability in multifamily investments. By understanding and addressing the pitfalls of inaccurate income projections, underestimating expenses, poor due diligence, inadequate risk assessment, and neglecting regulatory considerations, you can make more informed decisions and protect your investments. Remember, diligence, research, and staying informed are key to mastering multifamily underwriting.

I invite you to share your experiences or ask questions in the comment section, as we can all learn from each other’s insights and build a vibrant community of knowledgeable multifamily investors and underwriters.

The post Mastering Multifamily Underwriting: Avoiding Common Pitfalls first appeared on Horizonten Properties.

I argue that cap rate as a return metric fails to tell us the entire story. In fact, it tells us very little about the asset and its potential. This becomes more and more true the further the asset is from a stabilized state (e.g., the heavier the value-add). Take a 100-unit property with current average rents at $1000/mo. running at a 50% expense ratio (operating expenses equal 50% of income). This property generates $600,000 in net operating income ([$1,000 x 100 x 12] x 0.5). If the asking price for this property were $12,000,000, the cap going-in cap rate would be 5% ($600,000 ÷ $12,000,000). If the going market cap rate for assets like this one is 6%, then this asset seems way overpriced on the surface. But what if you learn that the property is experiencing a very high loss to lease (LTL), meaning their leases are severely under market rates? Similar units in the area are renting for $1,300/mo. and the subject property will only require about $1,000/unit in capital expenditures to compete with comparable properties. In addition, we also learn that the property has been run very inefficiently, and new ownership will have no problem running this particular asset at a 40% expense ratio. This is where the cap rate leaves us high and dry, and yield on cost comes in to give us a way to evaluate and fairly compare this value-add opportunity to others. 

The yield on cost (YOC) is calculated by dividing stabilized NOI by total project costs (stabilized NOI ÷ total project cost). Here, the denominator will include purchase price, capital expenditures, sponsor fees, and acquisition/financing costs. Assuming $500,000 for closing costs, this investment’s YOC would be 7.4%. This number is much more helpful when comparing two investment opportunities as it tells a much fuller story than the cap rate. This is because it includes the stabilized performance of the property and the costs associated with executing the business plan. In contrast, the cap rate considers the current NOI and purchase price alone. 

Taking it a step further, we can calculate something called a development spread. A development spread is the difference between the YOC and the market cap rate. It quantifies the value the business plan will add to the asset in the current market context. In our example above, the opportunity provides a 1.4% development spread (7.4% – 6%). Further, dividing the development spread by the market cap rate gives us the development lift, which indicates the value added as a percentage of the market cap rate. The example above shows a 23.3% development lift (1.4% ÷ 6%). This metric is helpful when comparing two opportunities in different markets or across asset classes (or any situation where market cap rates vary between assets).

While the cap rate certainly has its utility, I hope you can see that YOC and development lift tell a much more valuable story when evaluating and comparing two or more value-add opportunities.

Thank you for taking the time to read this article, and consider sharing if you found value! Always feel free to reach out with questions or comments!

Dream bigger,

Jaden George

The post Yield on Cost vs. Cap Rate When Evaluating Value-Add Commercial Real Estate first appeared on Horizonten Properties.

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