Commercial Investment Real Estate March/April 2016 | Page 18

INVESTMENT
ANALYSIS
Beyond
Cap Rates
Test assumptions to make
informed sale decisions.
Capitalization rates for multifamily properties appear to have
stabilized at very low levels after a veritable free-fall in major
metropolitan markets since the end of the Great Recession. The
drop in cap rates appears to be the result of low cost permanent
fi nancing, the perceived long-term stability of apartments as an
asset class, and a lack of yield in other industry segments.
Investors purchase apartment
projects in major markets as soon
as they are listed — or in some cases
before they are listed. T e historically
low interest rates provided by perma-
nent lenders — Fannie Mae, Freddie
Mac, conduits (until recently), and
some local and regional banks —
make acquisitions at high prices per
unit and correspondingly low cap
rates feasible. However, going-in cap
rates tell only part of the story for
long-term investors.
Discounted Cash Flow
Many real estate professionals
eschew the use of 10-year discounted
cash f ow models to value multifam-
ily properties because income and
expense growth is typically forecast
at a steady pace and because replace-
ment reserves are assumed to be f at
through the holding period. It is
true that it is simpler to forecast the
10-year performance of multifam-
ily projects than it is to forecast the
1 16 6
March
Ma
Mar
arch
ar
c h | A
ch
April
p r ri i l | 20
pri
pr
2
2016
0 1
16
6
performance of of ce and retail over
the same period. It is not true that
this assumed predictability lessens
the need to analyze the performance
of multifamily projects over a hold-
ing period, especially when compar-
ing apartment projects with varying
operating expense structures.
Two stabilized apartment projects
may generate an identical net oper-
ating income af er reserves, but it is
the operating expense ratio and the
potential volatility of certain operat-
ing expenses that will make or break
targeted returns.
A Comparison
For example, assume that two sta-
bilized multifamily properties are
94 percent occupied and that each
has an NOI of $1,000,000. Property
A has an expense ratio of 33 percent
(utilities sub-metered) and Property
B has an expense ratio of 60 percent
(utilities master-metered). Armed
with this information, the follow-
ing basic operating statements can
be constructed from the bottom up.
If NOI is capped at 6.0 per-
cent, the value of each property is
$16,666,666. Assuming a f rst mort-
gage of $13,300,000 (80 percent of
the purchase price) at 4.0 percent
on a 30-year amortization schedule,
the debt service coverage ratios for
the properties are 1.31x and the debt
yields are 7.52 percent in year one.
Both acquisitions require cash equity
contributions of $3,366,666 (without
transaction costs).
Assume that rents at Property A
increase at 2.0 percent per annum
and that expenses increase at 2.5 per-
cent per annum over a 10-year hold-
ing period. Also assume that rents at
Property B increase at 2.0 percent per
annum but that expenses increase at
3.0 percent per annum.
T e 0.5 percent increase in annual
expense escalations for Property B is
an attempt to account for the higher
uncertainty associated with the
master-metered utilities at Property
B. T e DSCR for Property A in year
11 is 1.56x and the debt yield on the
outstanding principal balance at the
end of year 10 is 11.34 percent. T e
same metrics for Property B are 1.37x
and 9.94 percent, respectively.
Additionally, the value of Property
Commercial Investment Real Estate
by David L. Church, CCIM