Underwrite a Rental Property in 4 Steps
Step 1: Determine your unit mix and calculate total rents
The first step is to sum up all the individual rent and calculate out the annual total rent.
We also repeat this calculation at market rents instead of in-place rents to see the return on the investment or property after you execute your business plan.
There may be additional revenues at the property level such as parking, laundry, storage, or antenna revenue.
The final part of this step is to sum and annualize the property revenues to determine Potential Gross Revenue. Potential Gross Revenue (PGR) is the sum of all property related income, including unit and miscellaneous income. Remember, we should calculate two scenarios out; one for in-place rents, and the second for stabilized rents.
Step 2: Vacancy and Expenses
Now that top line revenues are determined, the next step is to apply a stabilized vacancy factor and determine the property’s expenses.
Vacancy or turnover is a natural aspect of any multifamily building. Depending on the market, typical vacancy rates can range anywhere from 2% to 10%. Most stabilized vacancy assumptions are 5-8%.
For property expenses, some common ones are:
Property Management (if not self-managing)
Property Tax
Insurance
Repairs and Maintenance (R&M)
Utilities
Landscaping
Salaries (in cases of dedicated staff such as a maintenance person or on-site staff)
Most apartment buildings have an average annual expense ratio of 35-50% of revenues depending on the building's rents, age, and location.
Which expenses are excluded from Net Operating Income?
Not all expenses are included in operating expenses. Common exclusions are:
Capital expenditures (capex for short) like structural repairs, roofs replacements, pavement work, new appliances, and elevator replacements.
Mortgage payments.
Owner related expenses such as accounting, legal costs, travel, meals, and so on. In short, everything not property related and structural gets taken out of the expense number that is used to calculate net operating income.
Step 3: Net Operating Income and Final Cash Flow
Net Operating Income (NOI) is the net property cash flow before debt service and capex.
NOI = Total Revenues after Stabilized Vacancy - Total Expenses.
It is best practice to calculate two NOIs:
One as is one at the in-place rents, and
One at stabilized rents
That way, we can see our income growth after the unit has been brought up to market rent.
If you’re still reading, you may find my Rental Property Calculator helpful. You can buy the Excel template here.
At this point, the property proforma is complete and can analyze our in-place net operating income and our stabilized net operating income.
Step 4: Financing and Target Returns to Set Purchase Price
Capitalization Rate, commonly known as Cap Rate for short is the most popular metric used in real estate investments for measuring returns and comparing one real estate investment opportunity to another.
Cap Rate = Annual Net Operating Income / Purchase Price.
As an example, we have a property with $451,375 NOI that was purchased for $5,150,000. The Cap Rate = 451,375 / 5,150,000 = 8.76%. A riskier property will typically have a higher cap rate than a more secure property.
Now that you know your “going in” cap rate, you can compare to your stabilized cap rate (market rents), which you may only achieve in year 2 or year 3 of the hold. Ideally, your cap rate 2 years into the owning the asset is higher than your purchase cap rate.
In the below example, we see the cap rate increased from 8.76% going in, to 13.60% stabilized.
Cash on Cash, IRRs, and Levered Returns after Financing
Real estate is intrinsically connected to the capital markets. As interest rates rise, so do cap rates. This is because real estate is a heavily financed asset class, so as borrowing costs increase, the values of properties decrease to offset higher loan-carrying costs.
Cash on Cash is a common metric when you have a mortgage on an investment property. Cash on Cash tells the investor the percent (%) return they’re getting on their cash in the deal.
Cash on Cash = Cashflow after Debt Service / Cash Invested. Commonly referenced to on an annual basis.
Cashflow after Debt service = NOI - Total Mortgage Payments.
Internal Rate of Return or IRR is used to calculate the return of the project over multiple years. It is similar to a compounded annual growth rate.
Typical IRR targets for buyers today are 12-17% depending on how risky the deal is and certainty of execution.
There is no practical formula for calculating IRR, so we rely on Excel to do the heavy lifting by using Excel’s built-in =IRR formula. Mathematically speaking, the IRR is equal to the discount rate that sets the net present value of a stream of cashflows to 0.
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A final note from Prop Metrica Limited:
You can purchase the excel model we used here. The excel model also has 10 year projection with IRR functionalities.
