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Annualizing T1, T3, and/or T6 is best done when/if the reality at the property has changed over the last few months and you want to try to ascertain what a full year of that new reality might look like.
This is common during lease-up when the property has only recently, in the last few months, hit full occupancy. It is also common when concessions have burned off only in the last few months. Or in a market where conditions have dramatically changed recently and you want to assess the new normal.
In terms of T1 vs T3 vs T6. The fewer months you use to annualize, the more volatile the annualized value will be. T3 is probably the most common, as it’s more recent than T6 but it at least includes three months which help to smooth out lumpiness in certain line items.
Of course, the more history you have the better. So for a fully stabilized property in a consistent market, T12 always is better than an annualized T1, T3, or T6. And even more history than just a T12 is preferred. That’s why lenders like to see at least three years of operating history. The more history you have, the better a picture you have of the property.
Great questions!
1. Free and Clear return and Cash-on-Cash are generally calculated using Capital-To-Date. So this number may grow, if additional capital needs arise (e.g. leasing costs require capital call) but the number may also go down such as in the case of a refinance.
It’s important to remember that all metrics are simply tools to help make investment decisions. Thus, there’s no right and wrong answer necessarily. For instance, there may be a case where the investor wants to calculate CoC return based on initial capital outlay only, irrespective of changes in their capital account since. But most times, what the investor really cares to know is: what is my annual return on invested capital as measured by the CoC return metric. And thus, it becomes CFO ÷ however much the investor currently has invested in the asset.
Also I should point out, many investors have their own metrics they’ve developed. Or adaptations of common metrics to better suit their needs.
2. I’m not sure I follow the second question. When you say NOI yield, what metric exactly are you referring to? NOI ÷ Total Project Cost?
Sorry about that. I turned on re-takes for Michael’s last two quizzes. So you should be good to go.
Spencer
You could. I don’t, but not because it’s a bad idea! I honestly hadn’t ever considered it.
Thinking out loud. The same suggestion could be made about calculating property tax in a Direct Cap pro forma. But my process for building the pro forma usually involves manually thinking about and entering a property tax value. So making that input dynamic hasn’t really come up. But it would be an interesting thing to try!
Just as an FYI. You’ll find this out in later courses, but I avoid Excel’s Iterative Calculation option at all cost. This is for two reasons. One, Excel only iterates a certain number of times and then stops iterating. If you have enough circular formulas and the model is sufficiently complex, you can’t be sure Excel iterated enough times to provide an appropriate answer. So if you’ve ever seen an Excel model with Iterative Calc turned on, and after every cell update the outputs changes, that’s because it’s not getting to an answer.
And two. Iterative Calculation slows the Workbook down. Especially if the Workbook is complex. I’m a stickler for efficiently written models that run quickly. Nothing is worse than working in a Workbook that thinks after every cell change.
I show you the solutions I use to avoid turning on Iterative Calculation later in the Accelerator.
Hi Pratik,
1. This depends on the property and market. In some properties/markets, concessions are paid out as a rent deduction each month (e.g. 8% off per month), whereas others offer a true “free month” or two upfront.
By the way. I’ve also seen situations where the free month is offered on the backend – tenant pays rent the first 12 months, with the 13th month free.
Model concessions based on your market’s convention.
2. If you wanted to break out actual vacancy from loss due to incremental rent increases, I’d suggest adding an ‘Actual Vacancy’ line item and modeling that there. I didn’t do that in this case, but just as easily could have. I didn’t really think about it actually, but it’s a great suggestion!
Now why I wouldn’t include actual vacancy though in General Vacancy. That’s because of how I think of General Vacancy. For me, General Vacancy is a contingency of sorts. In essence, I want to hit every period with some reduction in income to account for possible vacancy and unknowns; and I use General Vacancy to do that. The A.CRE Apartment Development Model is probably overly punitive in this regard, since I’m taking a General Vacancy on unstabilized income – meaning I’m doubling counting vacancy.
It is common practice in the industry to use either the trailing 12 month (e.g. year 10) or forward-looking 12 month (e.g. year 11) net operating income for calculating reversion value. However, it is also quite common to then make adjustments to that NOI (i.e. the reversion NOI or reversion pro forma) to account for exactly what you’re describing.
So to your example. In many places, a property tax reassessment is triggered upon a sale. And so it becomes important to put some thought into the property tax amount used in the reversion pro forma.
So how do I model that? I set the reversion pro forma cells as inputs, and manually make adjustments to each line item as necessary. Because the property tax calc is circular, I hard code an approximate property tax amount based on what I estimate the assessed value will be at reversion.
Thanks for the question!
I’ll chime in here for Michael.
I’m glad you brought up the formula for calculating Equity Multiple (EMx) – it’s an important topic. Let me see if I can clear up any confusion you have around the definition of Equity Multiple (i.e. Multiple on Invested Capital or MOIC in traditional private equity), and why we use the Excel logic we do to calculate EMx.
First, Michael and I generally use the same Excel calculation to model EMx; we like the shorter and simpler SUMIF(+)/-SUMIF(-) logic. At first glance, this logic may not look like the EMx definition. So let’s dig into it.
In simple terms, Equity Multiple is the multiple by which invested capital grows over the analysis period. So if $1 USD goes in and $2 USD come out as a result of the $1 invested, the Equity Multiple is 2/1 or 2.00X.
You’ll often see the definition phrased as something like this: (Net Profit + Total Capital Invested) ÷ Total Capital Invested = EMx. But if you look at that phrasing, what it’s really saying is: (Total Distributions – Total Capital Invested + Total Capital Invested) ÷ Total Capital Invested = EMx. And that is overly cumbersome to model.
So for modeling purposes, I prefer to simplify the definition. I think Total Inflows ÷ Total Outflows = EMx, and calculate the metric in the same way.
In terms of the Excel logic. The SUMIF(+)/-SUMIF(-) logic Michael and I use simply sums the Total Inflows and divides that by a positive Total Outflows so that the resulting metric is positive. And the result is identical to modeling (Net Profit + Total Capital Invested) ÷ Total Capital Invested. Feel free to test this assertion out – it’s a healthy exercise that I too did when I was first taught this Excel logic for EMx.
Note that I discuss modeling Equity Multiple in more detail in course 3. I also discuss why I prefer to think of the cash flows in terms of being either inflows or outflows, and how it helps simplify more complex modeling tasks.
Thanks for the great question!
T12 refers to the “trailing 12 months”, which is the term for historical operating data from the past 12 consecutive months. Outside of real estate it’s more commonly referred to as TTM, but T12 (at least in the U.S.) is more commonly used in real estate
You’ll also see T1, T3, T6 used to refer to the annualized trailing one month, three month, and six month historicals.
Hey Shahmir,
You raise some good points. And in fact, you’ll find a lot of firms ignore loss-to-lease altogether, opting to instead wrap loss-to-lease in with their general vacancy assumption.
Personally I like to break out loss-to-lease from general vacancy because loss-to-lease and vacancy are distinct from one another. Sure, they both result in less income than the gross potential. But vacancy loss is lost income due to vacant units (i.e. downtime). Whereas, loss-to-lease is income loss due to under market contract rents.
Thus, breaking out the two line items tells a more complete story. A property with above-average loss-to-lease may signal stronger than normal rent growth in the submarket, or it may signal an issue with the leasing team. And in down markets you’ll sometimes see gain-to-lease, or contract rents that are actually higher than current market rents (e.g. Houston 2016). So breaking out loss-to-lease from vacancy helps get a more clear picture of property operations and the submarket.
Spencer
Hi David,
Thanks for the question. I have to admit, I’m way out over my skis on this one. Mainly because I’ve never used Excel for Mac. So I have to rely on what I can find on the internet!
Here are instructions on copy and paste a formula to another cell in Excel for Mac: Click here.
Here are instructions for other copy and paste options: Click here.
And here’s a long list of other keyboard shortcuts in Excel for Mac: Click here.
Hope that helps!
Spencer
Thanks for the question. This is a topic that Michael covers more in-depth in course 2 (Lecture 2.3), so I’ll hold off on getting too much into the theory behind the discount rate.
But in practice, determining the appropriate discount rate is really quite simple. In most cases the discount rate simply represents the investor’s target return. And an investor’s target return is generally a function of that investor’s cost of capital (i.e. the cost of debt and the cost of equity) plus what the investor needs to earn to make transacting worthwhile.
Also, in the course 2 forum we had a discussion on discount rates you might find interesting. That thread is here:
https://www.adventuresincre.com/academy/forums/topic/npv-discount-rate/
Let me know if that clears up the confusion,
Spencer
Hi,
Some great questions and I can understand the confusion with cap rates. Let me see if I can answer your questions, while sticking to the practical (and avoiding the theoretical).
In the real world, cap rates are used by buyers, sellers, developers, and owners to value real estate and make real estate investment decisions. So when a willing buyer and a willing seller agree on a cap rate and NOI, a transaction occurs. When buyers and sellers don’t agree, we call this a bid-ask gap and when it occurs on a macro-level it leads to reduced transaction volume (i.e. reduced liquidity) – note that this phenomenon is currently going on in the United States (click here for an interesting read on the subject).
My example in 2.5 is a scenario where there is no bid-ask gap. In fact, the buyer (us) is likely willing to pay more than what the seller is expecting. Thus the “whisper price”, which is essentially what the seller is expecting to get on the sale, is lower than what we as a buyer would be willing to pay.
Now keep in mind, this is not atypical in commercial real estate. Generally speaking, commercial real estate sales in the United States are managed through a bid process. The broker representing the seller first shares the opportunity with a pool of buyers (either publicly or privately) and gives a timeline for when first round bids are due. Buyers then perform their first round analysis and due diligence and submit bids on or before the due date (read Michael’s blog post on letters of intent).
And while the seller may have a price in mind, because buyers are competing with one another the buyers may offer more than what the seller is expecting in order to win the deal. They may also offer less of course, which is the bid-ask gap I mentioned above. And when there’s a bid-ask gap, often the seller will not accept any of the bids deeming it better to hold rather than sell at that price – this will make more sense once you complete the hold/sell analysis exercise in course 3.
In the case of Crescent Apartments from lecture 2.5, we believed that a 6.5% cap rate was appropriate. And just as importantly, we knew at 6.5% the seller would likely transact. Now 6.5% may not win the deal. There may be a buyer who gets comfortable with either a higher net operating income and/or lower cap rate, but at least at 6.5% we know it’s a deal worth spending time on.
That was a lot to digest, so feel free to ask follow-up questions if something is not entirely clear.
Spencer
