Commercial Investment Real Estate March/April 2016 | Page 19

A at the end of the holding period, less 3.0 percent for transaction costs, is $17,735,325 using a terminal cap rate of 6.5 percent, while the value of Property B is $15,540,850 (also using a 6.5 percent terminal cap rate) — a dif erence of almost $2,200,000. Obviously, ref nance risk at the end of 10 years is mark- edly less for Property A than for Property B. Lastly the leveraged pre-tax internal rate of return for Property A is 14.7 percent versus an IRR of 10.4 percent for Property B. T e analysis above is purely “by the num- bers” and, by definition, does not include non-quantitative factors. While the slightly higher annual growth rate in operating expenses attempts to take into account the uncertainty regarding the stability of utility costs for a master-metered property, spikes in utility costs would have a dramatic impact on the performance of Property B. As a result, the predictability of Property B’s cash f ows is much more dif cult to assess. Uncertainty is risk and a transaction with enhanced risk Gross potential rent Vacancy (6.0%) Effective gross income Operating expenses Net operating income Debt service Net cash fl ow Property A $1,595,745 $95,745 $1,500,000 $500,000 $1,000,000 $761,955 $238,045 should be modeled to generate a higher IRR to an investor. However, as the analysis shows, when the same dollar amount is paid for Prop- erty A and Property B, Property B actually yields a lower return — not the higher return that investors should expect. As this simple example illustrates, inves- tors need to be wary of purchasing multifam- ily projects based solely on going-in cap rate analysis. T e performance of various acquisi- tion targets needs to be analyzed with a focus on operating expense ratios, the allocation 100.0% 33.3% 66.7% Property B $2,659,574 $159,574 $2,500,000 $1,500,000 $1,000,000 $761,955 $238,045 100.0% 60.0% 40.0% of utility costs, and realistic projections for annual rent and expense escalations. Multi- family properties should be modeled over a 10-year holding period to test assumptions and make informed determinations about the value of the future benef ts being purchased. David L. Church, CCIM, is managing director at U.S. Realty Capital, LLC. Contact him at [email protected]. A version of this article fi rst appeared in the Mid-Atlantic Real Estate Journal. Have you updated your profile yet? THE NEW FindaCCIM.com Easy to use on any device. Visit your outdated profile before 50,000 potential clients do. Log in to CCIM.com to update your profile. CCIM.com March | April | 2016 17