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Pratik,
This is a very good observation – I was wondering if someone would bring it up!
I mentioned in the lecture that you’ll find loss-to-lease calculated slightly differently across the industry. The general definition/concept is consistent across use cases: “the difference between market rent and in-place rent”. But you’ll find varying methods to account for that difference.
In the Crescent Apartments and The Foles cases, we were underwriting existing assets with in-place operations. We had rent rolls with actual vacancy, market rent, and in-place rent values. So we were able to do a more thorough calculation of loss-to-lease.
The A.CRE Apartment Development on the other hand models a yet-to-be-built property. The number of occupied units at any point and the delta between in-place and market rent is not known and so to calculate loss-to-lease, some liberties had to be taken.
In my apartment development models, the loss-to-lease calculation is quite different. First, during lease-up it accounts for the difference between Gross Rent and actual occupancy. Second, once fully occupied the loss-to-lease calculation takes the annual rent growth factor and cuts it into 12 pieces. It applies 1/12 of the rent growth in the first month of each new growth year, 2/12 in the second month, 3/12 in the third month, and so forth. Thus, the only month in that year that enjoys the benefit of full rent growth is the 12th month. The following month then begins a new rent growth year, and the process starts all over. All of those calculations are taken on gross rent (i.e. on total number of unit, not on occupied units).
I think the lesson to be learned is that there’s often not just one way (or methodology) to model many of these concepts. You’ll see more examples of this phenomenon throughout the Accelerator. What’s important is to understand the concept your modeling, the methodology you’re using, and can justify the reason for using that methodology to model that concept.
Thanks for the great question!
Spencer
Dan – you’re all set in the backend. I noticed you missed a 2nd question on the quiz, but I can’t see on my end which one. Can I ask which one?
P.S. If you press the ‘Set as private reply’ below, you can keep your response private between the two of us.
You should be good to go. But just in case, I’ll look in the backend and make sure you’re showing as having passed/completed the course. If not, I’ll manually change it on my end.
Another good observation, and a typo (not even a legacy issue!). I’ve gone ahead and updated the template.
That is correct, it’s a legacy issue. I’ve corrected the mistake in 2.7.
Thanks for pointing it out!
A couple of great questions.
In terms of a guideline for stabilization, it really depends on the circumstance and who’s determining stabilization. A JV development partnership as an example will usually agree on a 3 – 6 month period of “full occupancy” before calling the newly developed property stabilized. “Stabilization” becomes important in this situation, since stabilization will trigger certain partnership-related events (e.g. burn-off of personal guarantees, option to sell or recap, etc.). Consequently, the sponsor/developer will push for a shorter stabilization trigger, whereas the limited partner will typically want more “seasoning” of income and expenses. So the period becomes an item for negotiation, subject to the supply/demand dynamics of the GP/LP market.
With that said for underwriting purposes (or how do we know what is stabilized income and expenses), T12 may not even be enough income and expense history to call the cash flows stabilized. That’s because, even after the property has reached full occupancy, certain items have not yet stabilized. For instance, payroll and marketing expense are generally higher during the lease-up period. Even after full occupancy, the operator may overspend on these categories until all 1st generation tenants have rolled. On the income side, while at full occupancy the owner may not be offering free rent anymore, there are still first generation tenants at the property enjoying the benefits of discounted rents (e.g. proportional free rent paid out monthly) offered during lease-up.
In terms of larger deals meriting a longer look-back. I’m not sure that’s the case. I mean, a large deal is in the eye of the beholder. A $50 million deal may be big to an ABC Capital while being small to a Blackstone.
I think how much history the underwriter requires is more a function of how conservative they are. A lender for instance will want to see more history than say a value-add investor. The lender wants to ensure there will be consistent cash flow to cover their debt service and considers past performance a good metric of the property’s future cash flow. A value-add investor on the other hand is less concerned about past performance, and more interested in the future potential.
Also,
What happens when you click these links:
Matt,
Sorry about that – it’s working on my end so not sure why that’s the case. Would you mind shooting me a screenshot of the error it gives you when you attempt to download the files? Send them to [email protected].
Also, are you able to download and open other Excel files in the course?
Spencer
You are splitting hairs, and that’s a good thing. In acquisitions they call that sharpening the pencil, and it’s often the difference between winning or losing a deal.
In practice, a lot more goes into underwriting concessions than my simple method here. I go more in depth on underwriting multifamily concessions in our Income Statements – Multifamily course
But the question you’re ultimately asking with direct cap underwriting is, what is likely to be the average concessions at the property over the long-term (remember the into perpetuity concept)? In multifamily that number is usually close to zero but I threw something into this exercise so I could introduce the concept.
So back to sharpening our pencils. In a back-of-the-envelope pass at a deal, if I believe there will be concessions long-term, I might use some simple/conservative methodology (e.g. % of rent). As the deal becomes more real, I’ll spend more time digging into concessions.
In multifamily underwriting, you’ll see it both ways – neither is incorrect. It really comes down to personal preference and/or how your firm prefers to handle it.
What’s most important is consistency – and this goes for all methodologies you follow in underwriting. Consistency leads to “rules of thumb” that help speed underwriting and make apples to apples comparisons between deals you underwrite.
Personally I prefer to place RUBS income above EGR. There are a couple reasons for this, but the main one is it gives me more transparency to how an asset is being operated. If I’m expecting the ratio of RUBS to Utility expenses (i.e. utility recovery rate) to be say 70% and the operator is only recovering 35%, there’s something I need to explore (perhaps an operating efficiency to be had that will add value?).
Great question!
