How to Underwrite a Multifamily Deal in 10 Key Steps

Underwriting a multifamily deal can be a daunting task, but breaking it down into key steps makes it more manageable.

Start by identifying the property type, which can be garden-style, high-rise, or mid-rise, and understanding the local market conditions, including rent growth and occupancy rates.

Research the property's financial performance, including its income statement, balance sheet, and cash flow statement, to determine its potential for returns.

Determine the property's value using a variety of methods, such as the income approach, sales comparison approach, and cost approach.

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To evaluate a multifamily deal effectively, you need to understand key metrics such as cash flow and net operating income.

The cash flow is the difference between a property's income and expenses, and it's a crucial indicator of the property's profitability. For example, a property generating $150,000 annually in rent with $100,000 in expenses has a cash flow of $50,000.

The net operating income (NOI) shows how much money the property generates before any debt payments are made. This helps you assess the property's potential for generating income.

A cap rate of 5% means that for every dollar invested in the property, you can expect to earn 5 cents in annual income. This simple calculation shows whether the property is likely to offer a solid return.

Several tools and resources are available to simplify the underwriting process and ensure accurate calculations. These tools can save you time and help you make smarter investment decisions.

Cash flow is the foundation of any successful real estate investment. It's the difference between income and expenses, which determines whether you're making a profit or loss.

A positive cash flow is a strong indicator that a property is generating profits, allowing you to cover debts and still have funds for repairs or reinvestment. This is especially true for multifamily deals, where a $30,000 cash flow, for instance, can make all the difference.

The cap rate is a measure of how much a building will earn on an annual basis, expressed as a percentage of its value. For example, a property with 100 units earning $1,000 per month in income and $800 per month in expenses would have a cash flow of $20,000 per year.

To calculate cash flow, you simply subtract operating expenses from total income. If the result is positive, you're on the right track. Platforms like Zillow Rental Manager and Rentometer can help you analyze rental income trends and compare properties, providing valuable insights into a property's potential performance.

Calculating operating expenses can be complicated because there are many factors that go into determining what a fair rent is for a unit. To calculate operating expenses, you must first determine how much income your property will generate each month.

Income is typically calculated by analyzing similar properties in the area or using an online rent analysis tool like Zillow Rental Manager or Rentometer.

To evaluate a deal effectively, there are a few key metrics you need to understand. These metrics will help you assess both the profitability and risks associated with the property.

The key metrics include cash flow, net operating income (NOI), and the capitalization rate (cap rate).

The cap rate helps you determine how profitable a property is. It's calculated by dividing the net operating income (NOI) by the property's current market value.

The formula for calculating the cap rate is: Cap Rate = Net Operating Income / Property Value.

For example, if a property generates $150,000 annually in rent with $100,000 in expenses, the cash flow is $50,000. If that property is valued at $1 million, the cap rate would be 5%.

A higher cap rate usually indicates a better return, but it can also signal higher risk.

To assess how efficiently the property generates income relative to its expenses, calculate the net operating income ratio (NOIR). The higher the ratio, the more efficiently the property is performing.

The formula for calculating the NOIR is: NOIR = NOI/Property Value.

For example, if a property's NOI is $80,000 and its value is $2 million, the NOIR would be 4%.

Here's a summary of the key metrics and their formulas:

By understanding and calculating these key metrics, you'll be able to evaluate a multifamily deal effectively and make informed investment decisions.

To estimate costs, you need to break down expenses into two categories: operating expenses and debt service. Operating expenses include taxes, insurance, and utilities, while debt service includes the mortgage payment, property taxes, and other obligations.

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Calculating operating expenses can be complicated, as there are many factors that determine fair rent for a unit. You'll need to analyze similar properties in the area or use online tools like Zillow Rental Manager or Rentometer to estimate monthly rents.

You should always start by estimating maintenance costs, which include landscaping, repairs and replacements, insurance premiums, and property taxes. These costs can significantly impact your cash flow.

Some common maintenance expenses to consider include:

To accurately estimate expenses, you'll need to review the current owner's "trailing 12" (T-12) document, which details the property's historical operations over the prior 12-month period. This will help you identify expenses that are being mismanaged and can be corrected with proper management and cost-saving methods.

Property taxes are typically one of the largest expenses and must be thoroughly examined prior to acquisition. Every municipality levies taxes differently, and extensive renovations or the sale of the property can trigger a property tax reassessment, resulting in higher taxes.

You should also consider the following expenses when estimating costs:

To calculate the net operating income ratio (NOIR), you'll need to determine the property's NOI and divide it by its value. A high NOIR indicates the property's income is well-managed after covering operating costs.

Making assumptions and projections is a crucial step in underwriting a multifamily deal. Accurate assumptions can make a significant difference in returns and property valuations.

Most investors will use a database like Yardi Matrix to gather data on historical rent growth values in the market and to reference growth projections for the next 3-4 years. If you don’t have access to a paid database, Zillow Research Data and Zumper Research can provide a general idea of rents in a market.

To make educated assumptions, consider market rent increases over time, as rent is almost always increasing. In the past few years, rent prices have soared across the nation, and it may continue to rise over the next decade. Analyze rent increases in your local market to determine a stable, reliable growth rate for your financial model.

To account for expected growth, investors should be able to account for at least the next 6-8 years of expected growth, depending on the planned duration of ownership. This will help you make informed decisions and create accurate projections on your deal.

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Here are some key assumptions to consider:

By making accurate assumptions and projections, you can create a solid financial model that helps you make informed decisions and secure a successful deal.

Making Growth and Vacancy Assumptions is a crucial step in creating accurate projections for a deal. A reliable financial model relies heavily on quality data, including assumptions about market rent growth and vacancy rates.

Market rent growth directly drives Net Operating Income (NOI), which in turn affects the projected sale price and ultimately the valuation of the deal. Investors often use databases like Yardi Matrix to gather data on historical rent growth values and reference growth projections for the next 3-4 years.

To make educated assumptions, you'll need to consider the specific market and property type. For instance, if you're analyzing a property in a market with a history of 1% year-over-year rent growth, using 5% year-over-year rent growth in your financial model may not be realistic.

Expense growth is another important factor to consider. Many investors use changes in the Consumer Price Index (CPI) as a proxy for operating expense growth, but property taxes can be a tricky one to estimate.

Here are some key considerations for making growth and vacancy assumptions:

By carefully considering these factors and making informed assumptions, you can create a reliable financial model that accurately reflects the potential of a deal.

Rent Premium Projections are a crucial part of making accurate financial projections for a multifamily investment property. These projections help determine how much you can increase rents after renovations are complete.

To make informed projections, it's essential to research comparable properties in the submarket that have already undergone similar renovations. You can use listing sites like Apartments.com to find these comparable properties and get a sense of what rents they're commanding post-renovation.

Looking at three to five comparable properties will help you identify patterns and determine a rent premium that's realistic for your property. This will ensure your cash flow projections are accurate and your valuation is reliable.

A good rule of thumb is to account for at least 6-8 years of expected growth when making rent premium projections. This will give you a stable and reliable growth rate to include in your financial model.

Here are some factors to consider when making rent premium projections:

By considering these factors and doing your research, you can make informed rent premium projections that will help you make accurate financial projections for your multifamily investment property.

Making debt assumptions is a crucial step in the acquisition process. Accurate assumptions around your total loan amount can significantly impact returns and property valuations.

You'll want to consider the interest rate, whether it's fixed or floating, and the amortization period and term. A fixed interest rate will provide stability, while a floating rate can be riskier.

Getting a quick turnaround on a term sheet from a lender can help you understand your loan terms and their impact on projected cash flows. This will also give you a clearer idea of the equity required to close on the asset.

Debt assumptions can make or break deals, so it's essential to get them right. If you're off on debt assumptions, you'll likely be off on your valuation as well.

Valuing the property is a crucial step in underwriting a multifamily deal. It's where you determine the property's worth based on its financial performance.

To value a property, multifamily investors use target return values for three key metrics: Internal Rate of Return (IRR), Equity Multiple, and Cash-on-Cash return. These metrics help them determine the property's potential to generate returns.

Most investors go into a deal with target figures for one, two, or all of these metrics, based on the returns they've promised equity investors or the risk profile of the individual deal. To back-solve for a target IRR, equity multiple, or cash-on-cash return, investors adjust the purchase price in their real estate financial model until the deal will achieve (or exceed) targeted investor returns on the property.

Here are the three key metrics used to value a property:

A multifamily property is a type of investment where multiple income streams are involved, making it a more complex process.

These properties typically have multiple units, such as apartments or condos, which generate rental income.

Unlike single-family homes, multifamily properties have more expenses to consider, including taxes, insurance, and ongoing maintenance.

You'll need to assess whether the property can generate enough profit to cover all these costs.

Mastering how to analyze a multifamily property's financials is crucial to making smart investment decisions.

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Financing costs are another important piece of the transaction puzzle that sponsors must underwrite, and they can significantly impact the overall value of a multifamily property.

The loan amount will indicate how much equity is needed to fund a deal, and understanding the different types of loan products available is crucial for accurate underwriting.

There are many different types of loan products, such as bridge financing and permanent financing, each with its own term, prepayment option, payment schedule, and interest rate.

Loans can be interest-only or amortizing, where both principal and interest are paid monthly, which can affect the overall cash flow of the property.

Sponsors rely on their network of loan professionals to obtain the best terms for their project, such as a loan at 75% loan-to-value with an interest rate of 5%, which is more suitable for a property with specific financial characteristics.

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The goal of valuation calculation is to determine a property's worth based on its projected cash flows and financial performance. Most multifamily investors use three key metrics to value a property: Internal Rate of Return (IRR), Equity Multiple, and Cash-on-Cash return.

These metrics are used to set target return values, which are then used to back-solve for a target IRR, equity multiple, or cash-on-cash return by adjusting the purchase price in the real estate financial model.

To calculate the Internal Rate of Return (IRR), you'll need to adjust the purchase price until the deal achieves the targeted investor returns. This involves evaluating the property's financials, including income, expenses, and potential risks.

A higher cap rate usually indicates a better return, but it can also signal higher risk. To calculate the cap rate, you'll need to divide the net operating income (NOI) by the property's current market value.

Here are the three key metrics used to value a multifamily property:

These metrics are used to determine whether a property can generate enough profit to cover all costs, including taxes, insurance, and ongoing maintenance.