Multifamily Underwriting: A Quick Analysis Trick
I sometimes underwrite a property, and the valuation feels “off” for whatever reason. My discounted cash flow model tells me the property is worth "X" from an IRR perspective, cap rates tie out with recent sales comps, and the debt coverage checks the lender's box. Even with all these return metrics telling me the property is worth $4 million, it doesn't feel right.
An old boss taught me a little trick to quickly vet a deal to ensure a proposed purchase price makes sense. While I have used this method primarily for apartment buildings, you could use it on any commercial real estate investment.
Questioning My Proforma Analysis
I was looking at a Class "C" property. The broker's guidance on this property was in the "high $70,000" ($76,000 - $79,000 per unit).
Paging through the offering memorandum and investigating the location, I thought this was finally a good opportunity that a broker had listed. It was a miracle in itself in this crazy competitive market. It appeared to be a well-maintained building in an underrated location. I thought I was onto something. I got the rent roll plugged in, the T12 financials uploaded, investigated the property tax comps, and made my assumptions.
Ultimately, my pricing peaked at only $65,000/unit, well below the broker's guidance.
I'm thinking:
Did I make a mistake?
Did I forget a couple of units?
Did I "0" out a revenue line item in my proforma instead of applying a growth rate?
I was sure this deal would fall in the $80,000 per unit range. I thought this because I recently valued a comparable property in a similar neighborhood at $75,000/unit that was objectively worse (location and poor property condition). I could not figure out why my value was penciling so low.
Multifamily Pricing Discrepancy
Usually, the rent always causes discrepancies with multifamily properties—specifically, the actual in-place leased rents (not market rents). The floor plans at the property will play a massive part in this. Bigger units tend to be worth more because they justify a higher rent.
I was confident that the analysis would yield a higher price per unit, but the unit types were only efficiency and one-bedroom units. The inferior property I looked at prior was primarily one-bedroom units with a few two-bedroom sprinkled and no studio units. Therefore, the larger average unit size commanded a more significant average rent, making it a pricier property even if it wasn't as appealing as the recent property I underwrote.
The "Capping Rent" Trick
To compare property valuations, I use a straightforward strategy. I take the difference between the average rents at two comparable properties, multiply it by 12 (or annualize it), and divide it by the market cap rate. Eight times out of ten, a pricing discrepancy will come solely from the rent differential.
Let's revisit the two deals I mentioned earlier.
Good Real EstateDeal (Perceived)
While this deal seemed solid, my proforma pricing was far below the broker's pricing guidance. Some details:
Average Unit Square Footage: 645
Average Rent: $710
My Valuation: $65,000/unit
Bad Real EstateDeal (Perceived)
Average Unit Square Footage: 730
Average Rent: $765
My Valuation: $75,000/unit
The Difference
If I take the difference in rent, annualize it, and divide it by the market cap rate (which I was landing on approximately a 6.25% cap on proforma Year 1), I get:
$765 - $710 = $55
$55 x 12 = $660
$660 / 6.25% = $10,560
The difference in my valuation came from the rental difference, which was more a function of larger units (more 2BRs) in the second building.
Note: This method doesn't work on distressed properties with occupancy issues. In theory, the properties you compare should be stabilized.
Other Quick Cap Rate Uses
This quick math isn't meant to replace your proforma underwriting analysis. I use it to validate my more sophisticated underwriting quickly.
If one property charges residents $35 per month for RUBS, a comparable property recently sold at a 5.75% cap didn't. What's that RUBS income worth?
$35 * 12 / 5.75% = $7,304/unit
Another helpful occurrence is comparing deals that bill residents for underground parking vs. surface parking included in rent. If an underground parking spot were $150/month at a 5% cap rate, that would be much additional value.
$150 x 12 / 5.00% = $36,000/unit
I've even capped two properties' historical net operating income (NOI) and then backtracked to find the line items leading to the most considerable discrepancy. Operating expenses such as a high water bill or exorbitant insurance can sometimes lead to a significant pricing difference. Then, it's up to you to determine if this delta is ownership-specific (aka something that operations can improve on with new property management).
Unfortunately, this analysis won't be possible unless you have comps you've underwritten. Lacking comps shouldn't be a problem if you regularly look at deals.
Summary
It's normal to do all the due diligence and still feel vulnerable that your multifamily valuation may be missing a vital component. Hopefully, this blog post gave you another tool for your analysis arsenal that will allow you to quickly verify your underwriting by comparing monthly rental charges, annualizing them, and capping them to determine their market value.
