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Six Secrets to “Juice Up” Your Underwriting
February 11, 2022
Disclaimer: This article is written tongue-in-cheek. Lone Star Capital does not employ nor endorse any of the following underwriting practices.
Are you underwriting deals but none of them seem to make sense? It doesn’t mean you’re too conservative, it just means you haven’t uncovered these magical, behind-the-scenes, ways to boost your numbers while making it look effortless. Every deal you underwrite from now on will look like a home run. Here are 6 ways you can “juice” your underwriting to make finding a great deal effortless or and make every deal a great deal.
Secret #1: Calculate your terminal valuation (sale price) using forward NOI and exclude replacement reserves from the NOI calculation.
The projected sale price has a huge impact on total projected returns. Projected sales prices are typically determined via an exit cap rate. Investors learn this early on and thus watch the exit cap rate like a hawk and are a bit incredulous when they don’t see cap rate expansion of at least 50 basis points (if you follow me, you know I take issue with this logic in a value-add scenario). However, the main point here is that the projected sale price can be manipulated to be higher in other ways than simply lowering the exit cap rate as that is only half of the equation. The other half is terminal NOI, or the NOI used to derive projected sale price. A nice and aggressive way to boost this is by using a “forward” NOI rather than a trailing one. The standard method is to use the trailing 12- month NOI for the projected sale year. For example, a sale projected in Year 5 should use Year 5 NOI. Alternatively, you could use Year 6 NOI (and grow rents by 3%, thank you very much) and eke out a little more value. The other way to boost your projected sale value is by excluding replacement reserves from the terminal NOI calculation. Whether you account for replacement reserve above or below the line (as operating expenses or as capital expenditures) doesn’t really matter in a cash flow context, but it makes a substantial difference in valuation. For example, if I’m going to put the standard $300/unit/year of replacement reserves below the line, I just “increased my NOI by $300/unit. If this income is valued at a terminal cap rate of 6%, I just increased the projected sale price by $5,000/unit ($300 divided by 6%). For a typical $100,000/unit property value, that is a 5% swing in value! Huge! And voila! Just doing these two things alone can transform a deal from okay to great.
Secret #2: Modeling rent growth based on aggressive research reports.
This one is pretty straightforward. You basically find the most aggressive but reputable research report that claims the market or submarket you’re buying is going to see 6% rent growth over the next year. You then plug in this growth assumption on top of the aggressive pro forma rents you’re projecting. Then, when you gradually back down your rent growth assumption over the following years, 3% rent growth all of a sudden looks conservative.
Secret #3: Year 1 cash flow kind of light? No problem, just raise a little extra in your operating reserves or capex budget then use those extra funds to gross up your cash flows to a robust 8% cash on cash.
Isn’t that like a Ponzi scheme?”, you might be wondering. Well, it depends. It only really negatively impacts investors if the promote is not subordinate to a return of capital. This means that if the “fake” cash flows are used to push up cash flows which then allows the sponsor to charge a promote on the residual cash flows, then yes, distributing a return OF capital as a return ON capital is bad for investors and increases the total equity basis of the deal which dilutes investors returns as well. If this discussion is somewhat confusing to you, I recommend checking out this article, You Have Been Promoted!, which delves into this topic in much more detail.
Secret #4: Underwrite cheap financing with a yield maintenance prepayment penalty but exclude any financing fees or prepayment penalties from projected sale proceeds calculations.
Most deals are financed with 10-year paper yet are underwritten to a 5-year hold. This creates a mismatch between the business plan and the debt since there is often a major prepayment penalty to reckon with if the loan is prepaid early on in its term. Nevertheless, I have never seen a sponsor underwrite any meaningful prepayment penalty in their model. Instead, sponsors must assume they will sell the deal with a loan assumption, forcing the buyer to take on the existing debt. There is no cost to the seller in terms of financing fees or prepayment penalties if the loan is assumed, however, the debt may be less attractive than what is available in the open market and therefore will reduce the sale price potential as the value can be held back by things such as amortization, low LTV, and high interest rate. If you want to include 10-year fixed rate financing with a yield maintenance prepayment penalty in your business plan, the best way to underwrite this is by forecasting a 10-year hold, making the business plan and loan coterminous, thus avoiding the omission of any brutal prepayment penalties in your model.
Secret #5: Magical Other Income
An easy way to boost your numbers without too much trouble is to assume easy increases in Other Income categories, such as reserved parking, utility billbacks (RUBS), pet fees/rent, valet trash, and furnished rentals. While being creative with ways to create additional income is great, it is easy to get too aggressive and assume the successful implementation of these various Other Income strategies across an entire property. However, these numbers are easy to overstate and are often overlooked by those evaluating deals.
Secret #6: Underwrite an unrealistically fast stabilization/renovations period while maintaining impossibly high occupancy.
Everyone has their own way of projecting the implementation of his or her value-add plan. In most cases, the combination of units renovated per month and occupancy is unrealistic. For example, while it may be possible to renovate 10 units in a month from a construction perspective, this would not be possible if you aimed to maintain 95% occupancy on a 100-unit property since there would only be 5 vacant apartments at any given time. Furthermore, assuming a 40% turnover rate, there would only be, on average, slightly more than 3 apartments per month vacated and available for renovation. While most investors scrutinize a sponsor’s business plan by evaluating their pro forma rents or exit cap rate, a quick stabilization timeline is a major assumption which can substantially “juice” your returns while flying under the radar.
Hopefully these six tips help you make the next average deal look like a home run and allow you to pay the crazy prices that sellers are asking today. If you’re instead looking to learn more about conservative underwriting, check out this article: Conservative Underwriting Fundamentals and buy my book on Amazon: The Definitive Guide to Underwriting Multifamily Acquisitions.