Forum Replies Created
-
Posts
-
I’ll add this to our list and look into it.
In full disclosure, I don’t have direct experience modeling LIHTC or HTC transaction, but have a very good friend who’s been in that world for a lot of years. I’ll discuss with him and see if I can’t collaborate with him to create something for this course.
You’re correct. I missed showing you how to do the error check. The completed model does include the formulas, but I’ll follow up with an update to the video to add the error check formulas.
In terms of how this module connects in your DCF. The Uses are modeled in your Investment Cash Flow section. Uses could be as simple as acquisition costs, or as complex as development budget forecast. If you’re modeling a complex capital stack like this, the Uses will most likely be either value-add or development budget cash flows.
How this module connects with the Equity waterfall is a whole different issue. If you recall from my ‘Introduction to Partnership-Level Modeling’, we calculated the contributions required of each partner by taking any negative cash flow in the property-level net levered cash flow line and splitting than based on each partner’s ownership share. Those contributions were assumed to be made pari passu (at the same time). However, partner contributions are not always pari passu, hence this module.
So to model non-pari passu partnership contributions, instead of following the methodology taught in the Partnership-Level Modeling course you would simply link the respective partners contributions line in the equity waterfall to their sources line within this module.
I’ll likewise follow up with a quick video showing you how you might link this module to your DCF and equity waterfall.
Thanks for the question!
No problem. Send over the Workbook at [email protected] and I’ll take a look.
Not at all. The system unintentionally unenrolled a handful of people from a few courses. Our tech team has done their best to manually identify those affected and fix on our end. But apparently they missed you! I’ll let them know so that you will have access again.
Sorry about that!
Spencer
Let me first say, you’re absolutely right that this is common right now! I think it’s more a reflection on where we are in the cycle, than on those sponsors knowing something the rest of us don’t. But remember, sponsors have capital to deploy. And at this point in the cycle, without outsized rent growth many deals just don’t pencil. So they drop in an overly aggressive and unsupportable rent growth assumption, use an unrealistically low vacancy assumption, assume little to no capital expenditures over the hold, layer in all IO debt, and voila – the deal works!
With that said, I think it is important to remember that the growth (or decline) of one line item is wholly distinct from the growth (or decline) of any another. I know in practice that we usually only assign an income growth and an expense growth assumption. But really, when sharpening your pencil, each line item should be considered independent of any other.
Property tax is likely to grow at a different tick than property insurance, which is likely to grow at a different tick than payroll. Similarly on the income side, rent is likely to grow at a different pace than parking income, which is likely to grow at a different pace than pet income. And so it goes for all line items in your model.
So at the end of the day, for most line items how much to assume for growth (or decline) is a matter of understanding the balance between supply and demand (imagine that!). If a market is underbuilt and rental demand outstrips the number of units available, rent will grow faster than average. Thus, you might be justified in using a more aggressive assumption for rent growth.
Similarly, if the local labor market is struggling and wages are flat, you might be able to support a payroll growth assumption below the long-term average. Or if parking is scarce in your CBD location and job growth in the submarket is robust, you might get comfortable with an above average parking income growth assumption.
Etc, etc etc.
Lesson for the day – and I’m not telling you anything you don’t already know. There is no wrong assumption, so long as it is supportable.
Thanks for the great topic!
Thanks for the question.
The best way to evaluate cap rates for mixed use properties is to separate out the NOI derived from each use and then apply a property type specific cap rate to each.
So for instance, imagine a mixed use retail and office building. Total NOI is 10 million. The retail accounts for 4 million and the office accounts for 6 million of NOI. Similar retail properties (excluding any office) are trading at 6% cap rates while comparable office properties are trading at 7% cap rates.
The direct cap value would be as follows:
Retail = 4,000,000 ÷ 6% = 66,666,667
Office = 6,000,000 ÷ 7% = 85,714,286
Total = 66,666,667 + 85,714,286 = 152,380,953Thus, when looking at comparable properties you would actually have two (or maybe three) comp sets. One for the retail component, one for the office component, and a third (possibly) of mixed use projects as a gut check.
Great question!
Unfortunately, no. This is one drawback to the WST Macro – there is no undo.
In fact, this is a drawback to all Macros (the WST Macro add-in is essentially a series of macros that run via keyboard shortcuts). So when you code a custom macro and run that macro, all previous actions saved to memory for the option to undo one or more of those actions at a later point (i.e. the undo stack), are wiped from memory. I’m not entirely sure why, but this is a common question asked on Excel forums (see here, here, and here).
Wish I had better news on this one!
Wesley – you are absolutely correct. That is an error. I’ll make the change in the source file and make note in the video so others don’t do the same.
Thankfully the case assumed no other income, or I’d have to update the results as well!
Thank you for spotting this and pointing it out.
Spencer
Ryan – Thanks for bringing this point up about how lenders view potential value. You’re absolutely correct that certain lenders (or loan programs ) will “lend into the value.” The “hold back” concept, sometimes also referred to (or structured) as an “earn-out” or “staged funding”, is a form of “structure” that lenders will use to recognize value when/if it’s created.
I think what’s important as we consider the lender’s perspective, is that prudent lenders lend on actual operating history and based on value that has already been created.
Sure, a lender may offer structure or size a loan based on the borrower’s projections. But the loan funds won’t be funded until that projection has been proved out.
Take for example a construction loan. Lenders size the loan amount and structure the loan terms based on the borrower’s projection of cost and lenders projection of value at completion and stabilization. However, loan funding is only made after the lender has verified actual construction progress and only in proportion to the actual costs deployed.
Likewise with those lender that offer earn-outs (i.e. hold backs, staged funding). The borrower says, “as-is rents are X, and we believe they’ll go to Y once we do Z.” And the lender responds, “Great! We’ll lend A based on your X rents, and are willing to lend an additional B once you prove out Y rents.” Again though, only after history has proven out the borrower’s projections will the lender fund.
We’ll get into this more in course 7. Introduction to Real Estate Debt.
Appreciate your contribution here!
First, let me explain grossing up for those unfamiliar with the concept. Most often properties have some vacancy each year. This is especially true of multifamily, where keeping a 300+ unit complex 100% occupied is quite the task.
[As a sidebar, it’s also worth mentioning that at a market rate apartment property, 100% occupancy is usually a bad thing. It generally means the operator is not maximizing rents. Most operators will target a 96% or 97% occupancy such that they find the right balance between max occupancy and max rent.]
But I digress.
So if the historical income statement of a property has vacancy in rents, the Other Income line items will have embedded vacancy as well. Meaning, the Other Income line items would have been higher had the property been 100% occupied. So for instance, imagine a property with average occupancy of 95% over the year. And imagine during the year that the property earned $95,000 in Other Income. The logic goes than, that had the property averaged 100% occupancy throughout the year =, Other Income would have been $100,000 (95,000 ÷ 0.95).
Thus, the process of adjusting a line item so as to be equal to some amount were the property 100% occupied is called ‘Grossing Up’.
So the question is, when to gross up Other Income line items. From a real estate underwriting perspective, there aren’t hard and fast rules for when to gross up Other Income. It’s a matter of what is the other income line item, and what is the incentive of the underwriter.
If you’re trying to maximize income in your pro forma (i.e. get aggressive), you can support grossing up Other Income when:
1) The line item is 100% positively correlated with occupancy. So mandatory cable income, for example.
2) The General Vacancy line calculates vacancy on Potential Gross Income, inclusive of Other Income. This is not always the case. A lot of professionals will only include rent in their General Vacancy calculation, in which case it would be necessary to include vacancy in the Other Income line items individually.It becomes more difficult to support grossing up Other Income when:
1) It’s unclear how impactful property occupancy is on a specific other income line item. For instance, parking income can be 100% positively correlated, or completely uncorrelated. So parking income in CBD office buildings may be uncorrelated while parking income in a suburban apartment complex is.
2) Vacancy is taken on rent but not on Other Income. Again, if the assumption is that the Other Income line item is positively correlated with occupancy, and you’re taking vacancy on rent. Than, it’s difficult to justify grossing up Other Income without taking vacancy on that Other Income.With that said, if you’ve read many of our Forum responses you’ll notice a common theme. How aggressive your underwriting depends on who in the transaction you are. If even you can support grossing up a line item, doesn’t mean you would/should.
So what you’ll find in real life is that:
The seller and selling broker are more likely to gross up Other Income (i.e. get aggressive), as their incentive is to maximize value.
The lender will be less likely to gross up Other Income (i.e. be more conservative), as they’re more concerned about the downside risk.
The buyer can go both ways. On the one hand, the buyer doesn’t want to overpay. And so they’ll push back against the seller for being too aggressive in the seller’s underwriting. At the same time, the buyer wants to win the deal and so will often have to find ways to justify the price to their investment committee. Grossing up Other Income is one way to justify more income to an investment committee, even if the realities are not quite so cut and dry.
Thanks for the great question!
This is a good question. I think it depends on who you are. If you’re a lender, you likely already value a fully stabilized property based on the actuals rather than the forecast. Lenders don’t buy the dream, they lend on the reality. Now I recognize there are lenders who underwrite more aggressively, but generally speaking the lender will look to the past more than to the future.
If you’re a seller, you’ll certainly value the property based on the forecast rather than the actuals. You’re trying to sell the dream, because the dream brings more money at closing. The broker works for the seller, and their job is to maximize proceeds to the seller. So they’ll push as far as the market (and ethics) will allow them to push.
And if you’re the buyer, it’s a balance between maximizing profits and winning deals. What’s most important is to recognize what’s realistic and what’s not. If payroll at the property for the last three years has averaged 1600/unit/yr, and the broker is underwriting 1200/unit/yr because “the current owner is running the operation heavy”, you have to ask yourself is that a realistic assumption to make?
Let me make a second point about the pro forma and the buyer. The direct cap pro forma and resulting asking price, from the buyer’s perspective, should be secondary to the DCF returns the buyer is solving for. Michael gets into this in course 2, but the purchase price is just one input that determines the ultimate outputs (i.e. equity multiple, IRR, average rate of return, etc). And those metrics aren’t solved for by doing a direct cap pro forma.
Hi Nick,
That’s interesting that you don’t see time value of money metrics used much in your niche of the housing world. In my experience, the return metrics a sponsor/GP uses is a function of what metric their investor partners require (and their lenders to a lesser extent). Thus, if their investor or lender partners aren’t requiring an IRR to fund the deal, why spend the time to learn to model an IRR!
I spent the first 10 years of my career in boutique residential development, and similar to your experience these metrics were rarely used in my sphere. I remember the first time I had to run an IRR for a real estate deal. We met with a potential investor who had been the CEO of a fortune 500 company. As we were nearing the end of the meeting we asked if he needed anything for him to make a decision, and he said “could you run me a DCF”. And I remember thinking, “what is a DCF!” Haha.
With that said, the industry is becoming increasingly more sophisticated and these metrics increasingly more important. While less than 40 years ago, large institutions (e.g. pension funds, sovereign wealth funds, life insurance companies, endowments, etc) didn’t even consider real estate a viable investment vehicle, today large institutions allocate nearly 11% of their portfolios to real estate, and that number is expected to continue to climb.
So I applaud you for putting in the effort to get exposed to different RE asset types and their various models.
Now, to your second point about deteriorating underwriting standards. That is a sign of a late cycle. When brokers and buyers have to stretch to make a deal work, you’re nearing the end. And that’s not specific to real estate. All asset bubbles are driven by crazy assumptions.
My advice is to have clear underwriting standards, and stick to them. It may mean fewer deals at certain points in the cycle, but it will keep you out of trouble. The firm I’m at right now is so very good at sticking to their underwriting standards, even if those of us on the front lines get frustrated at times when everyone else is loosening theirs to win more deals.
Anyway, thanks again for chiming in!
Spencer
Josh,
This is very interesting topic and quite appropriate for this course, so thanks for bringing it up. I’ll go through your questions one-by-one.
1. How do you guys go about maximizing your LTV or LTC ratio?
Really, at a certain point the max leverage you can get is largely out of your hands. How much leverage you can get is a function of the property and the borrower. At the point when you go out to market for debt, the max leverage really has already been set by the market, based on the type of property/tenant securing the loan and who the borrower is.
So to max leverage (without changing the property or borrower), its best to go to as many lenders as possible. The wider a net you cast, the more debt options available to you. Most firms accomplish this by using a capital markets advisor (i.e. mortgage broker), or sourcing multiple lending sources themselves. This creates competition between lenders, which in turn pushes lenders to get more aggressive on loan proceeds.
2. In your experience, is it significantly more risky?
Yes. The more leverage you employ, the riskier the deal becomes. So while the upside increases with leverage, so does the downside. I’ve put together a quick-and-dirty model to illustrate my point. (Click here to download the Excel file)
I created four scenarios. A base case with and without high leverage, and a downside case, with and without leverage. You’ll see that when a deal has downside, and it happens in the real world more often than you think, the more leverage that has been employed the closer a deal gets to failing.
1) The base scenario states: 2.0% NOI growth, 65% LTV loan, amortizing loan over 30 years, with no shock to NOI during the term.
– The resulting unlevered IRR is 6.82%, levered IRR is 9.24%
2) The base scenario with high leverage states: 2.0% NOI growth, 80% LTV loan, amortizing loan over 30 years, with no shock to NOI during the term.
– The resulting unlevered IRR is 6.82%, levered IRR is 13.60%
3) The downside scenario states: 0% NOI growth and a 10% reduction in NOI, 60% LTV loan, and interest-only.
– The resulting unlevered IRR is 3.46%, levered IRR is 1.08%
4) The downside scenario with high leverage states: 0% NOI growth and a 10% reduction in NOI, 80% LTV loan, and interest-only.
– The resulting unlevered IRR is 3.46%, levered IRR is -5.29%
And in the downside scenario with high leverage (#4), the LTV at maturity (year 10) is 97%, which means the borrower won’t be able to refinance the loan and thus it will lose both the property and the $2 million in equity invested in the property.
This is why open-end core funds and REITs use low leverage (30 – 40% max across the portfolio). If principal preservation is at all important, maxing out leverage can have devastating consequences; both to the borrower’s balance sheet as well as to their reputation.
3. And lastly, do you know of anyone who has gotten a deal/development close to 100% LTV or LTC? And how did that deal play out?
Loans on properties leased to investment grade, single-tenants will often get close to 100% LTV. Because the debt service is effectively an investment-grade bond due to the credit of the tenant and thus the lender deems the income safe, the lender will offer proceeds up to the point where debt service coverage is just shy of 1.00X. In low interest rate environments with relatively low debt service payments, LTVs in these cases can approach 100%.
Also, while not 100% LTV, many borrowers have $0 equity in a property. This occurs when the property increases in value such that the loan amount exceeds the initial cost to the borrower. This might occur on a development deal, where significant value was created to the point where the borrower pulls all of its equity out of an investment. Or more commonly, where a borrower has owned the property for a long time to the point where the loan amount on a refinance exceeds the initial cost to the borrower.
Thanks for the great questions.
1. In the real world, ideally you’d calculate the “average rent” yourself using the full rent roll. This allows you to make adjustments by individual unit and really dig into the rent roll. In lecture 1.4 of course 4d. Real Estate Income Statements – Multifamily, I show you how to work with full apartment rent rolls. At the end of the tutorial, I show you how to use the raw data from the rent roll, plus any adjustments you make to the data, to build a unit mix table like the one used in this course.
By the way, unit mix tables are also used in the real world, especially at the back-of-the-envelope stage. They generally will get you pretty close to your final underwritten gross rent, and they’re quick and easy to digest.
2. This is a really good point. While this is a modeling course and so I haven’t gotten into comp analysis much, ultimately all of the assumptions we make as real estate professionals must be supported. So the market rent you use in your analysis should be supported in some way. Ideally by looking at the experience of other comparable properties.
Based on the definition I’m using, no:
In ‘Current’, the borrower pays the interest in the month that the interest is charged. Thus from a modeling perspective, that interest cost is paid for by equity (i.e. the partner’s capital account grows accordingly). In ‘Accrual’, the construction interest is paid for by the debt; or in other words the interest is added to the loan balance each month with interest charged on accrued interest over time – hence the need for an interest reserve.
Then again, that’s based on my experience with institutional commercial investments and single-family residential development in the U.S. and Latin America. Perhaps with smaller deals, niche lenders, niche property types or in other countries, such a structure could be dreamed up. One of the things I love about real estate is that no two properties, no two markets, no two partnerships or capital structures are ever really the same. But generally speaking, the answer is no.
