Protect & (pre)Serve: Let’s Talk About Our Conservative Investment Philosophy & Process…
Constructing a property proforma is part art and part science. It is science in the sense that there are generally accepted principles upon which it is constructed, but it is art because it is fundamentally just an estimate built upon a series of assumptions.
“The three most important words in investing: Margin of Safety.” - Warren Buffett
“The function of the margin of safety is, in essence, that of rendering unnecessary an accurate estimate of the future.” - Benjamin Graham
The “meat” of this post reinforces and dives deeper into one of our most important investment philosophy elements: conservative underwriting.
Prior to making a commercial real estate investment, one of the most important tasks on a real estate investor’s to-do list is to create a financial projection of the property’s cash flows and Net Operating Income (NOI). This process is known as “underwriting” the property and the resulting financial projections are displayed in a document called a “proforma.”
One of the most challenging aspects of underwriting a commercial property investment is that the holding period can range anywhere from 3 – 15 years, or more. Projecting income and expenses over this time period requires the underwriter to make a series of assumptions about future property and economic conditions. Often, the success or failure of the investment depends on the accuracy of these assumptions so it is critically important that they be conservative.
For those of you looking into real estate investments, there are five critical assumptions that should be tested and challenged as part of the conservative underwriting process.
(FYI: Some of this may be a review to you from earlier blog posts!)
Entry & Exit Cap Rate
(see our post on cap rates)
Perhaps more than any other variable, the property’s purchase and sale price are the biggest drivers of investment return metrics.
The entry capitalization rate (“Cap” Rate) is calculated by dividing the property’s year 1 Net Operating Income by the estimated purchase price. This cap rate should be compared to recent sales for similar properties to ensure that it is reasonable. More importantly, the entry cap rate also provides a reference point for the exit cap rate.
The exit cap rate is a choice made by the underwriter to determine the sales price at the end of the investment period. It should be informed by the entry cap rate and adjusted for estimated market conditions at the time of sale. It is critically important that the exit cap rate assumption be conservative because the ultimate sales price has a meaningful impact on the total returns for the investment. As a general rule of thumb, investors should look for a 15 to 20 basis point increase in the cap rate for each year of the investment holding period. So, if a property was purchased with an entry cap rate of 6% and the estimated holding period is 10 years, it would make sense for the exit cap rate to be in the 7.2% – 7.8% range. This increase would account for the uncertainty in future market conditions. However, this “rule of thumb” is not always accurate and depending on certain expectations of a future market, investors may consider expanding this assumption or even contracting this assumption. For example, in the current market it is challenging to anticipate a significant expansion in multifamily cap rates.
Vacancy Rate
(see our post on vacancy rates)
When investing in a multi-tenant property, it is a given that there will be some vacancy during the holding period. To account for this, the underwriting model needs to include a line item for vacancy.
The vacancy assumption is driven by a number of data points including, the property type, tenant quality, number of units, location, supply and demand, and general economic conditions. Physical vacancy, meaning the number of empty units, impacts a property’s gross rental income and its ability to fund its operations so it should be minimized to the extent possible.
In a value-add investment, vacancy may start out high as the property is being repositioned, but it should stabilize over time. As a general of thumb, stabilized vacancy should be estimated at 5% – 10% of gross rental income, but is always highly location specific. Anything significantly different than this should be justified with as much data as possible.
Rent and Expense Growth
(see our post on rent growth + see our post on asset management)
Over a long period of time, inflation typically drives the cost for goods and services higher. A proforma should reflect this.
Aside from inflation, rental growth can be driven by a variety of factors including market supply and demand, seasonality, economic conditions, and property location. To account for these, a proforma should include an income growth assumption. As a general rule of thumb, it should be in the range of 2% – 3% annually. Anything appreciably different needs to be fully supported by market data.
Operating expenses are also driven higher by inflation. As such, an assumption needs to be made about their growth as well. Some expenses, like landscaping and some specific maintenance can run on multi-year contracts so they can be reasonably simple to forecast. Other expenses like property taxes can have significant increases after purchase, which must be considered. Further, other expenses like utilities and property management are variable. Property insurance can fluctuate on an annual basis as well. To account for this variability, a general expense growth assumption must be made. Generally, many proformas will assume between a 2% - 3% annual expense growth rate.
Financing Terms
(see our post on financing)
Using debt to purchase a CRE asset can help to boost returns. However, it can also raise the risk profile of the transaction in certain circumstances because the terms can change over the holding period.
In order to accurately model the cost of the debt, it is necessary to know all of the loan inputs like interest rate, term, amortization, loan-to-value ratio (LTV), and loan amount. These factors will impact the calculation of the required monthly payment, which is one of the most important proforma inputs.
In addition to the loan terms, it is also important to know whether or not there will be any loan covenants that require the property meet certain tests during the term of the loan. For example, it is common for a lender or financial institution to implement a debt-to-service coverage ratio (DSCR) covenant that requires the property’s income to be 1.25X the loan payment at all times. If there is a shortfall, it is a technical default and could mean that the lender calls the loan. Proforma results should be considered in the context of potential loan covenants.
Capital Expenditure (“capex”) Reserves
(see our post on capex)
Things break and the property’s physical condition degrades over time. As a result, things need to be replaced and renovated. The cost associated with these improvements can add up. To account for them, a certain amount of money should be set aside from the property’s operating income each month as reserves to pay for these future expenses. The exact amount varies by property type and size. For example, a common rule of thumb is $250 per unit, per year for a multifamily apartment building.
Failure to account for reserves can cause issues down the line if a major repair becomes necessary and there are no funds available to pay for it. Reserves should be adequately funded to avoid this issue.
Aside from this assumption in our underwriting, we always estimate capital expenditures ahead of making any investment, which generally are not expenses that impact NOI, rather improvements that are capitalized over the life of the investment.
Tying it Together
Constructing a property proforma is part art and part science. It is science in the sense that there are generally accepted principles upon which it is constructed, but it is art because it is fundamentally just an estimate built upon a series of assumptions. Every deal is completely unique.
To ensure the assumptions are as accurate as possible, and investments are as successful as possible for the long term, they should be conservative, based on market data, and within the generally accepted bounds of proforma construction. We, at CF Capital, remain committed to underwriting opportunities conservatively and making investment decisions with risk mitigation in mind.
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