All Forum Posts by: Scott Choppin

In a few recent conversations with different folks, it has come up how they are calculating financial performance on multi-family projects. And to be honest, I feel the need to generate a specific post on this, since in many of these conversations folks were mixing the financial ratios up between project types. Now, no one's going to die from this mix up, but it does speak to the identity of the person who is speaking the ratios. I am grounded that in all cases, investors, lenders, and land sellers will hold the person speaking in a different regard if they are accurate in their assessments of financial performance of real estate projects.

Generally, in the multi-family development and institutional level value-add markets, we use the following ratios:

NOI/Cost

Internal Rate of Return

Equity Multiple

Cash on Cash Equity Returns (ONLY on stabilized operations cash flow)

In Part 1 of a 2-part article, we'll delineate how to model an apartment project cashflow. Part 2 will delineate the calculation of the ratios.

Proforma Analysis

The basics of a financial model or “proforma” for a development project:

Income and Expense

Construction Period Cash Flow

Internal Rate of Return

Income and Expense Analysis

On apartment deal underwriting or financial analysis, we’ll first break it down very simply for you to gain an understanding of the fundamental components of income and expense analysis for an income producing property. Once you get that, you’ll be able to use it daily and effectively, then make it more complex as you get more seasoned in your underwriting skills. But as you underwrite deals, you will always be able to hold the basic structure in your mind, then work the details on each deal in a spreadsheet that you can easily build yourself.

Basic rental income and expense summary:

Rental Income from all units, also called Gross Income

Less Vacancy Factor (typically 5%)

Equals Gross Adjusted or Effective Gross Income (has various names, but this is what I call it)

Less Operating Expenses and Reserves

Equals Net Operating Income

This fundamental formula applies to all income producing properties, apartments, office, retail, self-storage, etc. Each component may have a different name, or be subject to slightly different allocation of cost (triple net office has the tenant pay most of the operating expenses and property taxes), but the bottom line number that we care about is Net Operating Income or NOI.

When you hear people talk about NOI, you'll know how that is defined (formula above). What it means is the amount of money or cash flow that is available to make the loan payment, and the amount of cash flow that can be used to value the property in a sale or refinance. Using this formula, combined with cap rates (see below), you can underwrite all types of income property investments.

Construction Cash Flow Analysis

This is the flow of expenditures during the construction period. This cash flow schedule is particular to a development project, as you will need to calculate the interest on borrowed funds and the preferred return paid on equity as a function of your construction period expenditures. A normal investment property doesn’t have major expenditures beyond the purchase, whereas a ground up development project has all the necessary expenditures to complete the units and lease them up.

The construction cash flow is nothing more than a spread of each construction cost line item over the specific time period of your construction schedule.

Generally, the time period of construction is derived during your initial due diligence and provided to you by your in-house construction team, or a third party general contractor. A rule of thumb is to always allow more time than you think to build. Unless, you are a production home builder constructing the same unit plan over and over again, a custom or one-off design can only be roughly assessed for total construction schedule. You always need to leave yourself extra time in your schedule. This can be for the normal friction of time loss due to city inspection delays, weather delays, RFI’s, and owner initiated plan changes. On the opposite end of the spectrum, you could assume significantly longer time periods for construction than your team indicates, but this will erode your financial returns due to overly conservative (meaning higher) amounts of interest carry and pref returns on equity. So you need to strike a balance, with some “cushion” to protect against normal friction.

Assessments of Value - Using Capitalization Rates

Once you have the NOI, you can then value the property using the Capitalization Rate or Cap Rate. These are market based assessments of value, that can then be used to underwrite your project. On a development deal (and on all "value add" deals) we have two cap rates:

1. Development cap rate, which is the NOI divided by the cost of the project, or NOI/Cost. When we speak, we say "NOI to Cost". This is what is used when running proformas to determine value at sale or refinance once the project is built out, leased up and producing income (or projecting these values during initial underwriting). This ratios is also used as a comparison tool for the market or what other development projects are producing with which we compete. You might say: "we are building to a 6% NOI/Cost, what are you building to?" or "the equity investor says they want a 7% minimum NOI/Cost, do our numbers meet that criteria?"

When an equity investor is making an assessment of your project, they will ask what is your NOI/Cost ratio (i.e. development cap rate). Example: Our Cedar project is producing somewhere over a 7.5% NOI/Cost. If other developers' project is producing a 7% ratio, our project is producing a superior offer or more NOI to each dollar of cost spent to produce that NOI.

2. Exit cap rate. This is the cap rate in the market upon sale of the project, that determines the value of project upon sale or refinance. This is derived by taking the NOI produced by your project and divide by the going cap rate gained from market research.

Example:

"Broker says that our project should sell at a 4.5% cap rate, our NOI is $100,000, so our value should $2.2M at sale" ($100,000 divided by .045 = $2,222,222).

Another way is that you actually sell at a price derived from a bidding process that you produce in the market, and then divide the sale price by the NOI to get the cap rate at sale: "Our sale price was $8.69M, our NOI was $400k, so our cap rate at sale was 4.6% ($8,690,000 divided by $400,000 = .046 or 4.6% cap rate)

The difference between the development cap rate (NOI/Cost) and the Exit Cap Rate is your development profit. Let's say you can develop to a 7.5% NOI/Cost and sell at a 4.5%. Your spread is 3%, which is the value you've produced as the developer. You may more simply say total sales prices less total project costs is your development profits, but I want you to see where we get the value for the sale or refinance first, then you can use that to subtract and calculate the profit. Of course, the market always dictates, so the more buyers you have bidding for your project the better the price you can demand. We always want to create an auction for our project when able. But the market sometimes goes against you, so you may not get an auction, or worst case, in a down market you may sell at an actual auction. But the main purpose of delineating cap rates here, is to understand the meaning of NOI in the creation and assessment of value for an income producing project.

Remember: when speaking with sophisticated investors, knowledge of these ratios and the ability to work them and speak them, will set you apart from the rest of the market.

Here is a sample proforma:

Proforma 

Construction Cash Flow Analysis

Internal Rate of Return Analysis

@Mitchell Krotz

One point of clarification, on the "Low Risk" scenarios, where you would sell the land, I meant all the land sale scenarios to be after you split the two lots. All land sale scenarios assumed in my mind that you keep the parcel with the existing building. After I reread my post, wasn't quite clear as I'd like. 

Good luck!

@Peter Wentworth

In your formula, you need to deduct the following additional costs:

1. Cost of lot/site improvements

2. Development impact fees

Normal formula for land development is called a "Residual Land Value" or RLV:

Market price per lot

Less site improvements (streets, curb/gutter/sidewalk, underground utilities, drainage, etc)

Less impact fees

Less soft costs (to design the site improvements)

Less other cost (brokerage fees, etc).

Developer profit may or may not be deducted from land, just depends on the builder, but if someone did that to me, I'd tell them their profit is in the homebuilding, but regional market differences drive this. All builders will look at it this way, at least the professionals will. 

Possibly you find a "greater fool" the pay you what you want/need to make your deal work, but you don't want to depend on that for your numbers to work. This is where "buy to make money" or "you make your money on the purchase" comes into play. You must buy this right, or risk holding the bag, when the lots don't sell for 150k. Also, check those lot sale prices for yourself, ask around for land brokers in the areas, that have knowledge of this site, or about lot sales generally. 

In some cases, you may do some of the upfront work yourself (say the site improvement plans), and deliver to the lot buyers the already completed site improvements plans, or do the site improvements yourself. In which case you would deduct those costs from the RLV but ADD to your profit calc: Your sale price to others - Your purchase price - your soft costs - less your site improvement costs = your profit. 

BUT... the profit you do want to generate is for you. Either in the form of cash profits or a free lot for your personal use. Don't do this ONLY to get the lot you want, you are taking risk, you should get paid profits to do that. I'm not saying you will, but you could lose on this deal. Buy it at a certain price but don't sell for 150k per lot, and you'll lose money.

Last thing, you have to ask yourself, what's the real reason the seller doesn't want to sell the lots individually. Oh I know what they TOLD you, but look at the deeper picture: Is there something they know that you don't, some problem, some government regulation or zoning that precludes the lot development from working, some environmental issue, anything that they could pass onto you as the new owner, that they don't want to deal with or risk they are trying to shift to a "greater fool" - don't be that guy. 

"Make your money on the buy" - Scott Choppin

~ Scott

@Pavan Sandhu

Pavan, let us know what you find out, I am always looking for new offers/technologies to save time/energy/money. 

Thanks!

@Chase Gochnauer

Looks good generally.

A few opinions/questions:

1. Watch the narrow/deep lots, not the best configuration for building homes.

2. Are the SFH lots correctly sized given competition in the marketplace, are your lots coherent with buyers of the lots (either builders or homeowners)?

3. Who exactly is your market, mostly builders, or sell to homeowners?

4. Can you sell the whole package at once to a builder? Best option, map the property, sell the whole thing, don't build anything.

5. Is there demand for the TH lots? Can you keep those lots, sell everything else, then build and rent the TH's for long term rental income?

6. Sounds like you already closed, do you have any Army Corps issues that came up in your due diligence, i.e. blue line streams? 

7. Any environmental/ecological issues? Wetlands? Rare birds, bees, lizards, nesting spotted white tipped owls?

8. From the topo, looks like you'll have a lot of mass grading, have you costed out the grading and does it pencil with what you can sell the lots for? Have you penciled infrastructure, same thing, does the cost work inside your financial feasibility model?

~ Scott

@Mitchell Krotz

Hi Mitchell:

You have such a great opportunity here. There are a few opportunities here, depending on your risk tolerance, ability to execute on a new build scenario , what the land is zoned for, and if your present lender (if there is one, encumber both parcels):

Higher Risk/Zoned for SFH

• - Split the lot from existing building parcel, build a new SFH, and sell it, keep the cash or pay down your basis in existing unit.
• - Vice versa: sell the old unit, keep the new unit (easier/lower cost maintenance in rental scenario), keep the cash or pay down basis of new unit
• - Split the lot from existing, build a new SFH, and rent it, hold long term

Splitting the lot (or un-tieing it as some call it), gives ability to sell units separately if needed, or to finance them separately with different lenders/banks if that is a better situation. Maybe one has a regular mortgage, the other has a HELOC for discretionary capital to do other deals. You can always encumber both lots with one loan at your discretion.

Higher Risk/Zoned for MFH

All the same scenarios above, just that you may be able to build more units on the vacant lot

Lower Risk Tactics

• - Sell the land now as is, easiest, nothing to manage or build, just sell it. Will generate least amount of value. 
• - Sell the land later, possible appreciation, still no build needed
• - Sell the land now or later, with full set of architectural plans without permits, no build. Slight value add.
• - Sell the land now or later, with full set of architectural plans, processed through city plan check (called RTI "Ready to issue" permit status). Still no build, value added with RTI plan and permits. More value add as compared to first two items this list.
• - Use vacant parcel after untie, as collateral for new loans to do other deals, use the raw asset value. Wont' be able to get HELOC, as no lender will loan HELOC against raw land. Hard money lenders will be most likely for success, but will still need to search many, as raw land loans are always perceived as high risk by all lenders, commercial or private.

If this were my deal, I would maximize value by preparing plans, complete plan check/RTI process, and sell. Max value without need to build. We call this an "entitlement" deal, where you the developer do all the prep, plan check,/RTI ,but sell without building. Max value with no build scenario. As I have said in other posts, the most money we have ever made in real estate, was finding a great parcel of land, completing the zoning and planning process, preparing the maps/plats, then sell that package (land + approvals).

~ Scott

@Sarah Lorenz

Great question. The answer is both. In this case the architect came up with the idea of the "double duplex" (4 unit) idea. So all the credit goes to him.

In other cases, we'll collaborate on solutions to issues either generated by a particular site or how a city works. 

Example, we are working on a new project, a triplex in city of Los Angeles, where the adjacent property has a 10' driveway easement over the lot we are working on, which is 42' wide. So we have 32' to work with (we can also use the driveway for our cars). The architect and our team batted ideas around, tried some designs we used previously and would prefer to use always, call it our prototype. But the backup space for the garages, typical for our prototype unit where the garage is located on the bottom of the unit didn't work (not enough feet to meet parking code). Together we came up with a  design where the parking is at the back of the site instead. 

Bottom line, he holds the building codes, he and I hold the zoning code and the build methodologies, and our team holds the cost/feasibility. Not to say our architect is indifferent to costs, he absolutely is (and I remind him regularly!!). Your choice of consultants should help you with this, not hurt you. 

As the developer, our team and myself must always track and prioritize all design ideas/changes/solutions against cost/timing/profit. It's ultimately our and our investors bottom line, so we watch it closely!!

Hi Juan

First, nice work on the sales video, beautiful neighborhood, excellent drone shots. 

Second, please email me directly with pertinent info, may have investors that would consider Denver. 

Email: [email protected]

Thanks.

We will be starting construction here in the next 2-3 weeks given our present schedule. We are working on two major task groups:

The make ready process, those items required to be in place to actually start construction. When we are at this stage it's always really important to be very vigilant regarding the list of items to make ready, and to be actively tracking them with your team (early this morning I sent a list of follow up items that I am tracking on this project to my partners in the deal and my team). The reason is the incredible amount of friction (a term you seen me use often) which are all those little things that stand in the way of starting. 

Examples would be permits, but I am really meaning more granular items in this stage: the paperwork that goes to the school district to sign off on payment of school fees, the county sewer connection application and fee payment, the public works department sign off on existing sewer location, on and on and on. This is where a great project manager really makes a difference (maybe that PM is you) to be constantly checking status on a million little processes. 

So here's what we are working on:

1. Building, grading, demolition, temporary power pole, and all other needed city permits. This includes numerous paperwork needed, such as special inspection certifications (who will do them), grading bonds, county sewer connection application, public works alley land dedication sign off, planning department sign off, fire department sign off, temp power pole permit application, etc.

2. Fee payments - school fees, county sewer fees, permit fees, development impact fees

3. Utility disconnection - in SoCal the timing for these can be very long, a few weeks in some cases, so you don't want to wait, be ready to start, and then find out your gas connection is still active, and no demolition can take place.

4. Asbestos Survey and AQMD Demolition Notification - required whether ACM (Asbestos Containing Material) is present or not. If present, you ASB removal contractor will prepare and submit. If no ACM, then demolition contractor submits. Requires a fee either way.

5. Site preparation - install temp power pole, stage const. office trailer, install site fencing, stage temp. toilet, install erosion control (straw waddles, silt fence, rock entry), install temp water, install site web camera.

The other major task group we are working on is the selection of subcontractors, and if warranted, a general contractor. 

The methods of running construction on a project like this are:

A. General Contractor model - hire a third party GC, let them run the construction.

B. CM Prime Subcontractor model - where the developer or ownership entity is the construction manager (but not a GC) and all subcontractors sign prime (direct) contracts with the owner. Sometimes the CM can be a third party, and not the developer. 

C. Owner General Contractor - developer holds a general contractors license and run the construction process in house. I sometimes call this the "Homebuilder" model, as most major homebuilders run their projects this way. 

In the last two models, it is critical to have built a network of subcontractors that are trustworthy and competent to deliver on budget and on schedule performance.

This is where I see a lot of folks new to the business have breakdowns, they either haven't or can't build their networks effectively - either general contractor or subcontractor networks. That's why you hear so many horror stories here on BP and in the market generally. And by the way, we experience it too. Sometimes generals or subs just fall apart, personal issues, financial issues, people get sick and unfortunately they die. These all effect human organizations, it's just more prevalent in the construction industry. As projects, generals, and subs get bigger, these issues tend to be less. But at the small and medium end of the construction markets you'll see this more often, and need to plan accordingly.

In my next post I'll layout ways to make assessments of generals and subcontractors to help avoid making the wrong choices.

Scott

Hi Everyone:

It's been quiet, as we have been in the midst of the plan check process with the city. While it has gone reasonably well, there are some lessons to pass on here. No matter how long I've been doing this, there's always some new twist and turn in the process.

For this project we ran into two issues:

1. The code changed this year, (beginning of 2017) from the 2013 code to the 2016 code. 

This is important because each time a code is updated, there will be changes in the requirements for the project that you, your team, or most likely your architect will have to deal with for the first time. In most cases, on simple projects, this doesn't put too much friction in the process. You can and should always anticipate, that in a code change year, that it will take longer to produce a set of plans, and that your design team will be under more pressure to produce plans on the same schedule. Because of course, as the developer driving the process, you want the plans produced in the exact same time period (or sooner) that the team did before. In a code change year, it's powerful to anticipate friction or breakdown, and plan around that. This is no ones fault particularly, as our project designs are similar from project to project. However, there is enough variation in the project plans, and more particularly, because we build in multiple cities, the additive complexity of new rules and different cities slows the process down. 

2. Codes are interpreted by your local city, and more particularly, by the building department and a specific person who is ultimately the senior responsible person at the city. In CA, we call this person the "chief building official". That person is the ultimate arbiter of code interpretations for a project. 

Why is this important? As you work in each city, they will interpret and apply the codes in different ways from other cities, and you may on occasion run into breakdowns related to how they apply the code. 

On this project, we wanted to fit 4 units on the site, with front and rear setbacks, with a specific unit type (town house, family unit), guest parking, common open space, driveway, trash enclosures, utility locations, and other site planning details. This drove an unusual need to design the unit layouts such that the units, that are attached in row (or were in the original design) side by side, needed to overlap each other in small ways. An example of this, is that in one unit, a bedroom on the second floor of one unit, cantilevered over the first floor garage on the unit next door. Now in most cases, as apartment units, this is not a big deal. In our case though, due to this overlap, the need for fire separation between units, and the fact that we had no living space on the ground floor, the city made the interpretation that there were multifamily units (normally what we want) AND that they required elevator access to all floors above the 1st floor (normally in a town house unit what we don't want). 

We've worked in Long Beach a long time, but this unit and project type (town house rental) has not been done in Long Beach for decades, and the new codes and new interpretations of the codes came to be important in a negative way. On single townhome units we DO NOT want to put an elevator in each unit, too expensive as you would expect. An alternative way to design the project, would be to put common upper floor walkways to the entrance of each unit (called "catwalks") and have all units served by just one elevator. But this was not at all our design intent, much less that our UTH project type, is highly sensitive to non-rent producing costs, and which we must avoid or eliminate. We spend time eliminating all costs that can be, to increase the efficiency of rent produced as a function of costs spent. We call this NOI/Cost, and we want the ratio to be as high as possible. This ratio calculates a dollar of NOI produced by dollars of cost to build.

So we went back and forth with the city, who hadn't seen a rental townhouse in many years (they've seen for-sale towns, but a different animal in many ways). We came up with the idea of separating the 4 units into two duplex units on the same lot. 

This resolved the elevator/catwalk issue, and actually created a nice common open space that was less so in the early design. It put some pressure on the unit design, but nothing that we couldn't get comfortable with and did not require any crazy construction solutions or costs.

I'll end this post here (GC selection next post shortly) and say:

Fundamentally you must always plan for a certain amount of friction on a development project. This is why the profit per project is higher in most cases than a value add apartment deal. More strategic knowledge, more friction, more risk, more profits. The better you anticipate the friction, plan for the friction, and underwrite your proformas with this factor, the better off you'll be. For new developers (and some veterans) surprise is the enemy.

Development deals are more complicated and have more moving parts to manage. I read and watch Grant Cardone as part of my competitive learning practices, and he had a really good way of looking at it, to paraphrase: Complexity is the enemy of profits, keep it simple. 

Of course you'll say, Scott why then do you do development deals, and I'll answer: Development requires a high degree of strategic knowledge, and can be highly profitable. It's a niche, and not everyone can or chooses to do it. This give us a competitive advantage. But we also want to simplify in every possible way the development offers that we make. This is why we created the UTH housing concept, to develop and build a very very simple yet in high demand residential product. We've eliminated parking podium/garages, complex structural design, reduced complexity in all design facets, systems, specifications, etc.

So we stay in the domain where we have a high amount of hard-to-obtain strategic knowledge (i.e. development) combined with a simplified residential product, delivered into a highly supply constrained market, to families that have a deep need for our housing offer. This is the formula that we have created that we believe will have a long term demand arc.

Scott