All Forum Posts by: Scott Choppin

Continuation from Part 1 of this series: https://www.biggerpockets.com/forums/44/topics/723267-apartment-financial-underwriting-part-1-of-a-2-part-series

Apartment Financial Underwriting - Part 2 of a 2 Part Series

Investment Yield Ratios

In Part 1 of this series, we covered the basic organization and structure of an apartment proforma, income and expense summary, and a construction cash flow schedule.

In this 2nd part, we'll cover investment yield ratios that we utilize as a professional development company, to analyze the return characteristics to determine if a project is worthwhile in our initial underwriting, as well as, provide final financial return reporting on completed projects.

In the development business, these are the major financial ratios used to measure investment yields on equity investment by professional developers, institutional level and mid-size equity investors:

Internal Rate of Return

Equity Multiple

ROI or Cash on Cash

Internal Rate of Return

First, the textbook definition:

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company's required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Now, the real world definition:

IRR is the rate of return produced by investing equity into a development project at the beginning of a project's investment cycle (this could be cash used for predevelopment costs, land close, and funds for construction) and getting repayment of original investment plus yield on the invested capital at the end of the project. The major advantage to using IRR, is that it takes into account the time/value of an investment, and allows IRR or rates of return to be compared between investments with different time cycles. You can compare an equity investment for a project that takes 1 year to invest and repay, to a project that takes 7 years to invest and repay, then choose which produces the higher IRR. This is why IRR is used by sophisticated and institutional level investors.

Understand this: the longer an investment takes timewise, the more likely the total IRR will be lower and trend downward. As well, the opposite is true, if the investment time cycle of a project is very short, the IRR could spike very high, especially when an investment period is under one year.

Once the first dollar of equity is invested then the clock to calculate the IRR starts and ends upon the final repayment of the original equity investment, any preferred return (called "pref") and the backend profit splits allocated to the equity investor. We'll explain more about the practical aspects and presentation of IRR's when we write about raising capital in the equity markets.

One item to remember: IRR is not an assessment of risk, and is an assessment of generated returns on invested equity over a given time period. Although IRR can be used to compare investment choices as stated above, you as the developer must make an assessment of risk and any associated mitigations to risk in order to effectively compare potential investments.

Equity Multiple

First, the textbook definition: A ratio dividing the total net profit plus the maximum amount of equity invested by the maximum amount of equity invested. The Equity Multiple (EM) of an investment does not take into account when the return is made and does not reflect the risk profile of the offering or any other variables potentially affecting the project’s return.

There basic formulaic structure for EM:

Equity multiple = cumulative distributed returns / paid-in equity

or

Equity multiple = paid-in equity+yield on equity / paid-in equity

The way I think of equity multiple pragmatically is this: What's the ratio of the dollars I get back based on dollars I put in? EM is a way to measure the whole dollar return of the project given the investment. Many times an institutional investor or fund wants to achieve a certain amount of dollars back from the investment, say 2 dollars for every dollar invested, or a 2.0 equity multiple. This can help them measure and account for the time, energy, and money they invested. Is it worth investing in, if it does or does not return a certain amount of whole dollars?

As an example: An equity multiple of 1.3 is less attractive to an investor versus 2.0 multiple. EM is a static measurement and does NOT account for the time value of money in the measurement. It just says plainly: How much money do I invest, and how much money do I get back, and what is that ratio?

Example: We invested $50,000 in equity in the project, and received total distributions of $100,000. So our EM is 2.0. But, if the time period for the payout was 18 month the IRR might be 40%, but if paid over 10 years the IRR might be 15%*.

* these examples are simplified for this explanation and are not real measurement of yield.

You really want to use IRR and Equity Multiple in tandem, each to measure yield on the project in different ways. IRR is a dynamic measurement of yield that accounts for the time value of money and total investment returns over time. EM is that ratio or measure of the total magnitude of generated yield in terms of whole dollars.

Cash on Cash (COC) Return or Return on Investment (ROI)

COC/ROI = Yield*/Paid-In Equity

* In this case, yield could be total profits generated from the sale of property, or it could be annualized cash flows from income producing projects.

This is a simplified method of calculating yields on equity investments. It is (or can be) a dynamic measurement of yield if applied to ongoing cash flows generated from net rental income. When applied to a one time capital event, a sale for example, it is a static measurement. Some non-institutional investors use ROI as their preferred measurement, in many cases because calculating IRR is a more complicated calculation. But like EM, it does not take into account net present values of cash flows over time, and therefore is not completely accurate and usable to compare alternative investment choices. For our company, we like to use COC to measure the potential annual net cash flows when underwriting development projects that may be long term hold candidates.

Hi Everyone:

BP has erased all the YT links put in this thread that we posted over the last year or so, which is fair, terms of use say they can make any change they want anytime. 

To continue to provide value and make this thread of some use, I am going to list the subject matter of the videos, in order, so that if you want to view them, you'll know what's there (they're located on the biggest web video platform on earth). 

Generally, if you watch this series, it will take you through every major phase of a new construction apartment build. This will equip you with a clear understanding of the steps of a project build, in order of build, such that you can understand the process from the developers standpoint. 

Here you go (excuse my multiple mug shots):

I will be posting the underground utilities info next week.

@William Coet

Great question. 

This means we are raising equity that will stay in the deal for 7-10 years - i.e. "Long Term Hold". 

This is in contrast to a "merchant build" project, where we would build, rent, then sell immediately. 

Let me know if that helps.

~Scott

@Jay Johal

@Greg Dickerson and I had this conversation a couple of days ago, but in a slightly different way. In that conversation, I expressed my assessment is that we are due for a recession - albeit our expectation is this next one will not be predominantly a real estate centric downturn. We expect rents will remain relatively stable in non-podium, non-Millenial rental housing, i.e. B and C product, workforce housing etc. We ground our assessment related to general rent stability on stats from the '08-'10 period in the last recession, where CoStar rental rate tracking showed almost no change in average rental rates across the SoCal market. Of course, all need to be aware of their micromarket situation, and assumes good management, etc. We believe with the vast supply constraint in middle market rental housing, no oversupply in that sector, and stable middle income families as renters, rents will be stable generally. 

We are presently raising long term hold equity on new deals, with the logic that rents in these specific product types will remain stable, and that a longer term hold period - 7-10 years, would allow sufficient time to ride out the recession. Values in MF will/may fall, but if you can plan on lower leverage on a purchase, or lower leverage at permanent loan funding once a new construction project is stabilized, that would provide some relative amount of insulation against valuation decrease in a downturn scenario.

Yes, love the hustle.

This is an article I wrote last year, and has received more attention and likes on BP and LI than any other article I've ever written. I wanted to post it again, driven by a recent message I received from a gentleman named Luke Emblem (look him up on LI). Luke emailed me this:

"In the last 7 months I have managed to gain an internship at a small Real Estate Development/Student Housing Company in my college town. I work 20 hours a week and have thus far been exposed to re-zoning,site plan control, landlording, managing and getting bids from contractors, valuation and a myriad of other miscellaneous tasks.

I got this job by taking your advice and reaching out to local Developers, I sent cold (personalized) emails to 15 companies and ended up going to lunch with my current boss and hitting it off. This summer I'm taking on a more active Project Manager type role with the company, working full time as I don't have school.

I want to thank you for the great content that you put out, it's been truly helpful and I've surprised my current boss several times with the knowledge and insight that I have gained from your posts. I enjoy the way you lay out your expertise in an easy to understand manner and appreciate the fact that you put it out on such a public platform....

Regarding your question on the knowledge that I gained from your posts that surprised my boss, the most memorable moment was during my interview. He asked me what I thought developers did and I was able to correctly identify the different phases of a development in my answer - this knowledge came directly from your thread on the Cedar project. I made sure to emphasize the role of zoning, the difference between building "by right" and "entitlement" and the risk/reward that comes with both options. This impressed him, and sparked a conversation on the significant NIMBY movement in our town."

The main thing I want to highlight, is that if you want to start and build your career in the RED business, you have to build your base of strategic knowledge and your identity in the RED business. To do either of these, you need exposure to the business in real working environments, and for that you must make powerful offers to work for others that raises you above the crowd to get hired on, and you must make what I call - an uncommon offer. An offer that rises above the numerous people who say they want to start, but never do....so here's the article again. I am hopeful this will spark a vigorous conversation about beginning in the RED space.

6 Ways to Build a Career in the Real Estate Development Business

by Scott K. Choppin

In my daily conversations and interactions online, I get the question almost daily of how to break into the real estate development business. Whether you are just deciding on your career, or are a seasoned veteran looking to make a move, this post was written to provide value in your efforts to build a career in the development business.

Get the right college degree

While there are many paths to a career in the real estate development business, one of the first things to do is focus on the right college degree. While being a developer does not require a degree, to get the right first job, does.

The following degrees are often in the background of those who have entered the business:

Civil Engineering

Architecture

Finance

Accounting

City and Urban Planning

Build your networks early

Build your networks early, either during college or once you enter the business. To build your networks, and facilitate choices for your first job (see below)

• Local industry networks, including local builders exchange, local and regional homebuilders association. An example in California is the Golden State Builders Exchange. Occasionally they will hold local mixer events, market updates, or hold monthly meetings.
• National industry networks, such as homebuilders and multi-family associations. Examples would be the National Multi-Housing Council or the National Association of Home Builders (usually affiliated with local HBA’s per above). Many of these national groups have regional student chapters. The national groups will hold annual meetings, and regional conferences.
• Attend local real estate meetups. While these are mostly made up on investors, these investors most likely know local developers. You can find meetup that are happening on a weekly basis in larger cities.
• Attended real estate conferences. An example in California, is the Pacific Coast Builders Conference. Search for your local or regional conference.

Your goal here is to meet as many people as you can, and gently let them know you are seeking a position with a real estate development company, and ask if they might know of anyone. A powerful way to approach anyone is the indirect approach: “Do you know of anyone who might be looking to hire or that is seeking an intern?”

Get the right first job

As a developer in training, you want a first job that exposes you to the maximum amount of the development cycle with the maximum possible learning velocity (time and speed). You will need to learn all of these components of a development deal: land acquisition, site selection and sourcing, zoning and entitlements, architectural design management, deal underwriting, financing, construction, leasing, property management, and sale or asset management.

I would suggest working for companies that already develop the types of projects that you are ambitious to build in the future. One word of caution, don't take a first job that is oriented around construction or construction management, I have found it very hard for folks to move from construction to development without some loss of career traction to do so.

For example, I come from a family of real estate developers, but I was ambitious to learn rapidly and work for others in the multi-family development domain, so I obtained my first job (asst. project manager) for a division of KB Home (Kaufman and Broad Multi-Housing) that developed in-house apartment projects. I started as a rookie assistant project manager, and left there as a seasoned senior project manager running the entire project myself from finding the land to putting the project into long term asset management phase. This gave me the exposure to all aspects of a development deal on multiple larger ground up development deals.

Your likely job title will be: assistant project manager, analyst, development associate. Whatever it is, you will be working for a more seasoned project manager or senior project manager.

To find companies, search in your local area:

Google search for news about company activities, company announcements, new projects, public hearings, phase releases (new units released to the market), new hires or promotions.

Google search and look for advertising for new projects selling or renting units and identify the developer.

Get a development internship

An alternative, if you are finding a job a challenge, offer yourself up as an intern for a small development company, with the express purpose of gaining development experience, or at least that's how you should communicate it to them. You may have to work for free or at low cost to the small company, as they will be very sensitive to cash flow and costs.

Get a mentor

This is the single most important part of the advice in this article. A mentor could be someone you work for at a company, a senior project manager or VP of development. It could be someone you intern for, or just an individual that you have met and attracted into your network.

Know this: that person is worth their weight in gold, and can be the primary person that you run things past or ask questions as you move through your day. They can help you move up rapidly, and avoid pitfalls in your career. Development is a complicated business, the more knowledge you can acquire with more velocity improves your ability to increase your income.

Personally, my best days were when I would be tasked with managing a project (or part of it) and could at the end of the day ask a TON of questions about how to do it, what happened, what went wrong, what could be done better, and what could be done better than anyone else. I used to carpool home with a very seasoned PM, and we would be in the car together for 1-2 hours each day, and that poor guy got squeezed dry like a sponge by me for knowledge and information. He and I still laugh about it today, but that was the best learning I ever did. I have made a point over my career to ask questions all the time, to everyone I can. You’ll learn to ask them professionally as you hone this practice. Be open to learning for your entire career, the speed of change in all markets today demand constant and never ending learning.

Give yourself plenty of time to build your career

One caveat, building your career will take some time. Development as I said before is a complicated and a risky business; there are many facets to what we do daily, and you want to give yourself the time to learn it thoroughly. Mistakes here can be truly costly. Think of Malcom Gladwell’s 10,000 hour principle, that it takes this amount of time to become “expert” at something.

Be ambitious, be strategic, move first, move fast, persist.

In a few recent conversations with different folks, it has come up how they are calculating financial performance on multi-family projects. I feel the need to write an article on this, since in many of these conversations folks were mixing the financial ratios up between rental and for-sale project types. Having clarity when speaking about real estate financial analysis goes 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 multi-family 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 this Part 1 of a 2-part article, we'll delineate how to model an apartment project cashflows. 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 Income and Expense Summary

Construction Cash Flow Analysis

Internal Rate of Return Analysis

@Artur Polyak

Welcome to the forum. 

Tell us your specific objective your trying to fulfill with your questions, i.e. I need to learn how to find deals for my company, how do you all find deals? Etc.

Thanks.

Ok folks, 3rd times a charm. 

It appears that the forum rules have been amended, where YT links are no longer allowed. Any close follower of this thread has likely seen the previous posts to YT outlining the sequence of construction of a MF deal, where I understand that those old links will continue to be active. 

Presently, we have posted a new YT video, outlining the installation of the exterior stucco systems. I would encourage anyone to go there and you will see the updates. Fortunately, we are at the tail end of the video series, and so you haven't missed but a 3-4 additional videos to complete the series. They will remain on YT indefinitely.

Next video will post next week to cover installation of underground utility systems, then a couple more covering interior and exterior finishes. Once the construction phase is complete, we'll return to written posts here in this thread where we will debrief on the project, do's/dont's, investor IRR calcs, etc.

Hit me with questions.

~ Scott

@Mikael Winkler

We created this YouTube series to teach this exact learning process your going through, although created for new construction, it will be generally applicable to your process:

Real Estate Development - Lifecycle of a California Multifamily Project

Also, one of the more recent posts recommended doing one unit first, then the rest after. I would not recommend this, as you will increase your subcontractor or general contractor cost massively. Each time a sub needs to move in an out of a project it will drive up the costs. You will always get the best pricing, by giving them more work. The way to combat risk in this situation is get hard bids, although your knowledge level may not protect you from scope gaps.

Some folks recommended getting a partner or a mentor, which I encourage also. You might consider hiring a local retired general contractor on a flat small monthly fee or hourly fee, to be a resource for you (see scope gaps above), to get general advice, or sit in meetings with you as your advisor.

~ Scott