When offering a memorandum of a property deal lands in your inbox, flip to the model and look at these assumptions. This five-minute check can eliminate a bad deal in a short amount of time without having to spend a lot of time hearing the operator’s story of the opportunity.
This is the big driver of value creation. Capitalization rate is the net operating income of the property (calculated before debt costs) divided by value. The exit cap rate is largely determined by the market, so aside from an overzealous buyer paying up for a property at exit, it is prudent to remain cautious, which means modeling a higher exit cap when underwriting an exit cap rate for a property.
Summary of what to look for when analyzing exit cap rates:
An exit cap should never be lower than the cap rate at purchase. To remain conservative in reviewing deals, insist the exit cap be, at a minimum, 50-100 basis points above the going-in cap rate. Anything less than this spread is reason to question the driver of project returns to be mostly financial engineering and not representative of how the investment will perform.
Explanation:
For example, a property with a $1MM of NOI on a 10% cap rate is worth $10MM ($1MM divided by 10%), whereas the same property with the NOI on a 5% cap rate is worth $20MM. See how moving a cap rate can manipulate the value of an asset with a basic mathematical equation.
Most real estate investments are measured by IRR. When utilizing exit cap projections and leverage, modeled returns can vary dramatically. Here is a basic table to illustrate how leverage, combined with different exit cap rates, can model very different project IRRs:
Value at purchase= $20.0MM ($1MM divided by 5% cap rate).
|
Exit Cap |
Sale Price |
No leverage |
50% leverage |
75% leverage |
|
4% |
25,000,000 |
5% |
8% |
15% |
|
5% |
20,000,000 |
0% |
0% |
0% |
|
6% |
16,666,667 |
-4% |
-8% |
-20% |
Exit caps, often only one cell input in a large model, dramatically show returns, which can lead investors to place confidence in a deal which otherwise doesn’t merit a second look.
The general assumption regarding rent growth is that it grows at 3% a year, every year. The reality is rent growth, on average, grows at 3%/year, but some years will double digit rent growth, and some years may even be negative. Similar to exit cap rates, rent growth is largely determined by market forces.
Summary of what to look for when analyzing rent growth:
For deals with hold times of less than 3 years, it is prudent to underwrite closer to 0% rent growth. Deals with hold times approaching 10 years can be underwritten to 3% rent growth, as the average rent growth per year will normalize over longer periods of time.
Explanation:
For example, a property with a $1MM of NOI on a 10% cap rate is worth $10MM ($1MM divided by 10%), whereas the same property with the NOI on a 5% cap rate is worth $20MM. See how moving a cap rate can manipulate the value of an asset with a basic mathematical equation.
Here is a basic table showing the impact of various market-rate rent growth scenarios.
|
Rent Growth Scenario |
0% |
3% |
6% |
|
Purchase Price |
9,500,000 |
9,500,000 |
9,500,000 |
|
Year 1 NOI |
475,000 |
475,000 |
475,000 |
|
Year 5 NOI |
475,000 |
634,274 |
813,226 |
|
Value in Year 5 |
9,500,000 |
12,685,481 |
16,264,512 |
|
Value increase |
0% |
34% |
71% |
This table illustrates how modeling higher rent growth rates can model returns above reasonable expectations and inflate expected outcomes for a project.
When a property is acquired, operators will model unit rents expected during the hold period. These rents, not to be confused with market rate rent growth, are modeled as an assumed rental rate. Pro forma rents are often based on comps in the market and/or unit rental prices currently achieved within the acquired property.
Summary of what to look for when analyzing rent growth:
Similar to aggressive rent growth, inflated proforma rents after acquisition, be it due to renovation or estimates of what a manager can achieve under new ownership, should, generally speaking, not increase more than 10-15% due to a change in property manager or 20-30% for a physical unit renovation (inclusive of property manager change).
Explanation:
For example, a property with 100 units renting at $1,000/unit will produce an annual top-line revenue stream of $1,200,000 a year. This same property, but rented $1,300/unit achieves $1,560,000 in revenue. The same property rented at $1,500/unit will generate $1,800,000. To further expand on how this translates to value creation at the property, here is a table:
|
Rents per unit |
$1,000 |
$1,300 |
$1,500 |
|
100 unit Revenue (annually) |
1,200,000 |
1,560,000 |
1,800,000 |
|
Opex |
(630,000) |
(630,000) |
(630,000) |
|
NOI |
570,000 |
930,000 |
1,170,000 |
|
Value |
11,400,000 |
18,600,000 |
23,400,000 |
|
Property value increases over the Base Case |
Base Case |
63% |
105% |
This table illustrates how modeling proforma rents can model value increases in the property above realistic outcomes and produce artificially high displays of value creation.
Real estate deals can be very complex. Excel models with numerous tabs, inputs, and outputs can be overwhelming. By focusing on the three major inputs, exit cap rate, rent growth, and proforma rents, the initial review of a real estate deal can be conducted in a short amount of time. If these three variables are reasonable, further due diligence can be pursued.
Important Information
This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.
The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.
Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.
Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.
Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.