Real Estate Journal — June 12 - 25, 2015 — 13A
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M id A tlantic
C reative F inancing
By David Church, U.S. Realty Capital, LLC Beyond capitalization rates in multifamily properties
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apitalization rates have been in a veri- table free-fall in ma-
per annum and that expenses increase at 2.5% per annum over a 10-year holding period. I also assumed that rents at Property B increase at 2.0% per annum but that expenses increase at 3.0% per annum. The 0.5% increase in annual expense escalations for Prop- erty B is an attempt to account for the higher uncertainty associated with the master- metered utilities at Property B. The DSCR for Property A in year 11 is 1.56x and the DY on the outstanding principal balance at the end of year 10 is 11.34%while the same metrics
for Property B are 1.37x and 9.94%, respectively. Addition- ally, the value of Property A at the end of the holding pe- riod, less 3.0% for transaction costs, is $17,735,325 using a terminal cap rate of 6.5% while the value of Property B is $15,540,850 (also using a 6.5% terminal cap rate) – a dif- ference of almost $2,200,000. Obviously, refinance risk at the end of 10 years is markedly less for Property A than for Property B. Lastly the lever- aged pre-tax internal rate of return (IRR) for Property A is continued on page 15A
jor metropolitan markets over the past 24 months. The drop in capitalization rates appears to be the result of low cost permanent financing, the perceived long-term stability of multifamily properties as an asset class, and a lack of yield in other industry seg- ments. Investors purchase apart- ment projects in major mar- kets as soon as they are listed – or in some cases before they are listed. The historically low interest rates provided by permanent lenders – Fannie Mae, Freddie Mac, conduits and some local and regional banks - make acquisitions at high prices per unit and cor- respondingly low cap rates feasible. However, going-in cap rates tell only part of the story for long-term investors. Many real estate profession- als eschew the use of 10-year discounted cash flow models to value multifamily prop- erties because income and expense growth is typically forecast at a steady pace and because reserves for replace- ments are assumed to be flat through the holding period. It is true that it is simpler to forecast the 10-year perfor- mance of multifamily projects than it is to forecast the per- formance of office and retail over the same period. It is not true that this assumed pre- dictability lessens the need to analyze the performance of multifamily projects over a holding period, especially when comparing apartment projects with varying operat- ing expense structures. Two stabilized apartment projects may generate an identical net operating in- come (NOI) after reserves but it is the operating expense ra- tio and the potential volatility of certain operating expenses that will make or break tar- geted returns. For example, assume that two stabilized multifamily properties are 94% occupied and that each has an NOI of $1,000,000. Property A has an expense ratio of 33% (utilities sub-metered) and Property B has an expense ratio of 60% (utilities master-metered). Armed with this information, the following basic operating statements can be constructed from the bottom up.
If NOI is capped at 6.0%, the value of each property is $16,666,666. Assuming a first mortgage of $13,300,000 (80% of the purchase price) at 4.0% on a 30-year amortization schedule, the debt service coverage ratios (DSCR) for
the properties are 1.31x and the debt yields (DY) are 7.52% in year one. Both acquisitions require cash equity contribu- tions of $3,366,666 (without transaction costs). I assumed that rents at Property A increase at 2.0%
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