Underwriting 101 for Non-Finance Folks

Section 1. The Proforma 

Section 2. Underwriting
a. Market Study
b. Yield Study
c. Profitability Metrics
d. Sources and Uses

Section 3. Fundraising 
a. Debt – Local/regional banks vs private lenders
b. Equity - Self Funding vs taking on investors

Section 1 – The Proforma 

The image you see is a simplified proforma for a small development project. Don’t let the numbers scare you – we will break it down section by section, using simple examples. To start, let’s pause and understand the mechanism for value creation in real estate development:

The yield on Cost - Cap Rate = the Development Spread

(Net Operating Income aka NOI / Cap Rate) - (NOI / Yield on Cost) = Value Created

For those who haven’t seen these terms before, they are defined below:

Stabilized Net Operating Income is the annual net income received from your rentals after deducting vacancy costs and operating expenses.

• Stabilized Net Operating Income = Rent at full occupancy (aka Gross Potential) – Stabilized Vacancy - Expenses 

Yield on Cost measures the investment yield of the asset to the developer, or how much annual profit the stabilized project will generate relative to its Total Cost.

• Yield on Cost = Stabilized Net Operating Income / Total Project Cost Cap Rate measures the investment yield of the asset for the end buyer, or how much annual profit the buyer is receiving relative to their Purchase Price.

Cap Rate = Net Operating Income / Purchase Price 

Was this worth the headache? That ultimately depends on what you and your investors are looking for. But here are a few metrics we use to determine that:

Section 2 - Underwriting 

Underwriting is the process of running the numbers to gauge the profitability of a potential investment and see if it's worth the brain damage and the risk.

Your goal in underwriting is to identify all of the assumptions necessary to make a profitable project that is worth the brain damage and risk it takes to do it.

The first step in underwriting a development project is to calculate the yield on cost and compare it to the cap rate.

Calculating Yield on Cost 

The first step for calculating the yield is defining your rent and occupancy assumptions by commissioning a market study. This report should define the boundaries of your market and assess the rents and occupancy within it. If the market study shows there’s a ton of vacancy, then you may want to skip that project.

Once you’ve confirmed the rents and determined you have a reasonable chance at leasing up, the next step is to define how much square footage you can build by commissioning a massing study. This study should determine how much rentable square footage (RSF) you can squeeze out of the site. Generally speaking for infill markets - the more density you can build, the more your property will be worth.

Next, get out in the market and talk to people. The fun part about real estate is that it’s a people business – you have to talk to people to learn the market. Here are some things you’ll need to find out to complete your underwriting:

1. Vacancy and expense assumptions for your asset type in your market.

2. Total cost to build (including fees).

3. Cap rates for similar projects

With this info in hand, you can finish your underwriting. Multiply rent by total RSF to get gross potential rent, then subtract vacancy and op-ex to calculate NOI (Net Operating Income).

Divide NOI by Cap Rate to get your projected sales price, and compare it to your all-in cost. This is your total projected profit. Is it worth your time? That depends – to learn how to answer this question, please read below.

Determining if a project is worth pursuing

To determine if a project pencils, you need to consider the following things:

1. Who will the investors be (if any) and how long are they comfortable holding the asset for?

2. How long is the holding period?

3. What are the returns?

4. What is the risk?

Defining your Hold Period 

Your business plan can vary dramatically depending on you and your investors’ goals. Here are the two primary plans:

1. Long-term hold – Hold the property for cash flow, enjoy the tax benefits, and ride out long-term rent growth. This is best for HNW folks who don’t need their equity back anytime soon. This maximizes total proceeds.

2. Merchant build – Sell the property as soon as it’s leased up (or sooner). You will be selling for a lower price/ft than if you hold it a long time, but you will get your money sooner.

Calculating the returns 

Once you know your goals, here are 3 metrics you can use to gauge the profitability of your project.

1. Cash on Cash: Net Cashflow / Total Investment. This is your actual cash yield from the asset. You can compare this to owning a bond – it’s the actual % return you are earning on your money while it’s tied up in the asset. Depending on your situation, you may be able to include tax benefits in the numerator, further driving cash on cash for your investment.

2. IRR: total cashflows annualized over the hold period. The shorter your hold, the higher your IRR. Shortening the hold period drives IRR more than increasing sales proceeds does.

   • Most Real Estate Private Equity Firms derive their compensation from how well they perform on this metric. Most investors want to see 16%+ IRR for development projects, but some huge developers find investors willing to accept as low as 12% for trophy assets.

3. Equity Multiple: Total Distributions (net cashflow + proceeds from sale) / Total Investment. Generally speaking, the longer you hold the larger your multiple will be. Fully leased and seasoned properties generally command a higher price per square foot than newly delivered products because they have less lease-up risk. Rents also tend to go up over the hold period, and each $1 of net rent can add $10 or more in sales value. (Remember, NOI / Cap Rate = Sales Price)

   • Most investors want a 1.4 minimum multiple, or else it’s just not worth the brain damage and the risk. You can compare this figure to 10-year treasuries.

   • Most investors want to earn a spread over the treasury (T+ 1% at least) to make development worth the risk.

   • For long-term holds, you are focused on maximizing cash on cash return and total multiple.

   • For merchant builds you are focused on IRR subject to a minimum multiple.

Risk analysis 

Here are some questions I like to ask in order to determine if the returns are worth the risk

1. http://How much is my total investment?

2. How conservative are my underwriting assumptions?

3. How long will the project take to reach profitability?

4. In a worst-case scenario, how bad can the deal get?

Be careful when you are underwriting high IRR projects with big budgets and short holds. The total multiple might be low, meaning there’s a risk of asset value being lower than your total cost to build should the market turn on you.

Section 3 – Fundraising 

Once you’ve underwritten a project that appears to meet your team’s goals, the next step is putting together the Sources and Uses. This table summarizes the total project budget as well as the total sources of capital for funding the budget.

Sources, AKA total budget: You can put a bracket on these figures by asking for data points from architects, loan brokers, and GCs.

Uses, AKA capital stack used to fund the total budget: Generally, development projects are funded using a combination of both debt and equity. A loan broker can provide data points on how much you will be able to borrow to fund your deal.

Sources of Debt 

1. Local bank / Credit Union – lowest rates but will require you to personally guarantee repayment of the loan (aka recourse). This is typically the best execution available for loans of under $5 million, but they aren’t always open to funding construction costs.

2. Private lenders – high rates and high fees. This is sometimes the only group willing to make small construction loans.

Sources of Equity - the sample proforma provided assumes you are self-funding. Many sponsors raise Other Peoples' Money (OPM) through syndications or joint ventures (JV), which greatly reduces the sponsor’s total capital investment. Structures using OPM could be the topic of their own post, but I will provide a simple comparison of OPM vs self-funding below:

1. OPM: spread the risk, spread the reward. This requires complicated legal documents and a higher admin/accounting workload than if you fund the deal yourself.

2. Self-Funding: all your money, all your risk, all your reward. Simplest execution, least amount of legal and admin headache.

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Ready to invest or need help with any of the research above for your own projects? Schedule a 1-on-1 with us.