# Solution Walkthrough

> Illustrative teaching case. Northgate Commons is not a real property, this is not a real transaction, and the term sheet is not a real financing quote. Every figure is fabricated for instruction. Read this after you have attempted the model.

## Where your five checkpoints should land

| Checkpoint | Answer |
|---|---|
| Normalized year-one net operating income | **$1,090,004** |
| Supportable loan | **$10,634,000** |
| Binding test | **Minimum debt yield of 10.25%** |
| Unlevered IRR | **9.68%** |
| Levered IRR | **13.42%** |
| Equity multiple | **1.84x** |

---

## Step 1. The rent roll ties

Three figures on the December 2026 column of the operating statement should equal
the rent roll dated 2026-12-31, and they do:

| | Rent roll | December 2026 |
|---|---|---|
| Gross potential rent | $168,680 | $168,680 |
| Loss to lease | $7,445 | $7,445 |
| Vacancy loss | $8,505 | $8,505 |

What the rent roll tells you beyond the tie:

- **114 occupied of 120**, so 95%
  physical occupancy. Six vacant units at various stages of turn.
- **8 units on month-to-month.** Note that these carry a
  premium over market rent, so their loss to lease is negative. If you summed
  absolute values you would have overstated loss to lease. They are also the
  units most likely to leave, which is a business-plan fact rather than a
  modeling one.
- **Three long-tenured residents materially below market.** The largest gap is
  $410 a month on a
  single unit. Roughly
  15%
  of the total loss to lease sits in those three units, which is worth knowing
  because it is captured on turnover rather than at renewal.
- **Total loss to lease of $89,340 a year**, or
  4.4% of market rent. That is real upside, and
  none of it is underwritten in year one.

## Step 2. Normalized net operating income

Effective gross income is the trailing twelve months as reported:
**$1,865,006**. Nothing on the revenue side needs adjusting,
because the trailing period is what actually happened and year one is underwritten
without forward growth.

The expense side is where the work is.

### Trap 1: the management fee that is not there

The management fee line reads zero in all twenty-four months. That is not an
error. Note 1 in the statement disclosures says the seller has self-managed since
2009. Self-management is not free; it is unpriced. A buyer either hires a manager
or does the work and forgoes the fee they could have earned elsewhere. Either way
it is a cost of operating the asset, and the lender will underwrite one whether
or not you intend to hire.

The submarket survey puts the market fee at
3.0% of effective gross income for an
asset of this size.

    3.0% x $1,865,006 = $55,950

**Effect: ($55,950).**

A payroll line of $140,182 already exists for the on-site
manager and the maintenance technician. Those are site staff. The management fee
pays for the layer above them: the regional manager, accounting, reporting,
compliance, marketing systems. Adding the fee is not double counting.

### Trap 2: the roof in repairs and maintenance

Repairs and maintenance for calendar 2026 is $248,838,
which is $2,074 a unit. That is far
above what a 1986 garden asset with an on-site technician
usually runs.

Look at the monthly pattern. Eleven of the twelve months sit near
$5,220.
August 2026 is $191,415.
An operating expense does not behave that way. Note 2 confirms it: a full roof
replacement across all four buildings, charged to repairs and maintenance rather
than capitalized.

A roof replacement extends the life of the asset. It is capital. It comes out of
operating expenses entirely.

    $248,838 less $186,500 = $62,338

**Effect: $186,500.**

That is the one adjustment that moves net operating income up. It also means the
buyer does not need to budget a roof, which shows up again in the business plan.
The offering memorandum makes this same adjustment, correctly, in footnote 3.

### Trap 3: property taxes that are about to reset

The 2026 tax bill is $93,150, which is
$776 a unit. That is low, and the reason is
in the property notes: the assessed value is $6,900,000,
set against a property the seller has held since 2009 and never had reset.

County practice is to reassess to roughly 92%
of the recorded sale price in the tax year following a transfer.

    assessed value = $17,400,000 x 92% = $16,008,000
    tax            = $16,008,000 x 1.350% = $216,108

**Effect: ($122,958).**

This is the single largest adjustment and it is entirely mechanical. It has
nothing to do with how well you operate. It is also the one that catches people
who have only ever underwritten in jurisdictions that do not reassess on transfer.

### Replacement reserves

Not a trap, an underwriting assumption, and it is in the term sheet: the lender
escrows $300 per unit per year.

    $300 x 120 = $36,000

**Effect: ($36,000).**

### The bridge

| Step | Amount | Running |
|---|---|---|
| Reported 2026 net operating income (as the seller kept the books) | $1,118,412 | $1,118,412 |
| Remove roof replacement charged to repairs and maintenance (capital, not operating) | $186,500 | $1,304,912 |
| Add market management fee at 3.0% of effective gross income | ($55,950) | $1,248,962 |
| Reset property taxes to the post-sale reassessment | ($122,958) | $1,126,004 |
| Deduct replacement reserves at $300 per unit | ($36,000) | $1,090,004 |
| **Normalized year-one net operating income** | | **$1,090,004** |

> ### Normalized year-one net operating income: $1,090,004

Sanity checks on that figure:

- $9,083 per unit.
- Operating expense ratio 41.5% of effective gross income,
  which is a normal range for a value-add garden asset carrying a full tax reset.
- Going-in cap rate 6.26% at the guidance price, against
  sale comparables reported between
  5.85% and
  6.40%.

Notice what happened in the table above. Three adjustments cut net
operating income and one raised it.
Net of everything, the underwritten figure is
$28,408
below the seller's
reported number, which looks like almost nothing happened. It is a useful
reminder that a small net change can hide large offsetting movements, and that
the right answer here is not reachable by catching one trap and rounding.

## Step 3. Loan sizing

Full derivation is in `15-solution-loan-sizing.md`. The result:

| Test | Maximum loan |
|---|---|
| Maximum LTV of 65% | $11,310,000 |
| Minimum DSCR of 1.25x | $11,678,361 |
| Minimum debt yield of 10.25% | $10,634,185 **(binds)** |

> ### Supportable loan: $10,634,000, on the minimum debt yield of 10.25%

Sponsor equity is then price plus acquisition costs plus the origination fee,
less the loan:

    $17,400,000 + $217,500 + $106,340 - $10,634,000 = $7,089,840

## Step 4. The five-year projection

| Line | Y1 | Y2 | Y3 | Y4 | Y5 | Y6 |
|---|---|---|---|---|---|---|
| Effective gross income | $1,865,006 | $1,976,906 | $2,085,636 | $2,158,633 | $2,223,392 | $2,290,094 |
| Operating expenses ex fee | $719,052 | $740,624 | $762,842 | $785,728 | $809,299 | $833,578 |
| Management fee | $55,950 | $59,307 | $62,569 | $64,759 | $66,702 | $68,703 |
| Net operating income | **$1,090,004** | **$1,176,975** | **$1,260,225** | **$1,308,146** | **$1,347,391** | **$1,387,813** |
| Renovation capital | $323,000 | $323,000 | $323,000 | $0 | $0 | n/a |

Year 6 is projected for the exit only and is not a cash flow year.

Net operating income grows
5.4% a year compounded across
the hold, faster than the 3.0% expense growth
because revenue is growing faster in the first three years while the renovation
program runs and loss to lease burns off.

## Step 5. Exit

    Year 6 net operating income   $1,387,813
    Exit cap                      6.25%
    Gross sale price              $22,205,008
    Costs of sale                 ($388,588)
    Net sale proceeds             $21,816,420
    Loan payoff                   ($10,242,647)
    Net to equity at sale         $11,573,773

Gross sale price of $22,205,008 is
$185,042 per unit against
$145,000 paid. In real terms the value created is the
$297,809 of net operating income growth, slightly increased by
about 1 basis point of cap rate compression assumed at exit.

## Step 6. Returns

### Unlevered

| Year | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| Cash flow | ($17,617,500) | $767,004 | $853,975 | $937,225 | $1,308,146 | $23,163,811 |

> ### Unlevered IRR: 9.68%
> Multiple on total capital: 1.53x

### Levered

| Year | 0 | 1 | 2 | 3 | 4 | 5 |
|---|---|---|---|---|---|---|
| Cash flow | ($7,089,840) | $91,745 | $178,716 | $143,202 | $514,123 | $12,127,141 |

> ### Levered IRR: 13.42%
> ### Equity multiple: 1.84x

Total distributions of $13,054,927 on an equity check of
$7,089,840.

### Reading the two together

Levered IRR of 13.42% against unlevered
9.68% is positive leverage: the asset earns more than the
6.35% cost of the debt, so borrowing lifts the equity
return. The lift is about
374 basis points on
roughly 61% leverage.

Notice the shape of the levered cash flows. Years 1 through 3 distribute very
little, because renovation capital is consuming most of what the property throws
off, and year 3 is worse than year 2 because the interest-only period ends. Cash
on cash in year one is roughly
1.3%. A deal of this shape returns
most of its money at sale, which means the exit assumption is carrying more of
the answer than the operations are. That is worth saying out loud in the memo.

## Step 7. The recommendation

The sponsor hurdle is 15.0% levered. The deal
returns 13.42% at the guidance price, so it falls
short by roughly
158
basis points.

The useful output is not "pass." It is the price at which it clears. Solving the
model for a 15.0% levered IRR gives roughly
**$17,000,000**, or $141,667 per unit, a
discount of $400,000 and
2.3% to guidance.

Two things make the returns that sensitive to a small price move. Lower price
means less equity, and it also means a lower reassessed tax bill, which raises
net operating income in every year including the one being capitalized at exit.
Both effects run the same direction.

Solved by iterating the whole model on price, because the reassessment and the loan both move with price. Treat it as one reference point rather than a negotiating position.

### What would have to be true to pay the asking price

- Capturing part of the loss to lease in year one rather than none of it.
- The renovation premium holding across the remaining
  102 units, not just the
  18 already done.
- Meaningful cap rate compression at exit, beyond the sliver already embedded. The 6.25% exit cap sits about 1 basis point inside the 6.264% going-in cap, which is close enough to flat to be rounding rather than a value driver, so the exit assumption holds no cushion to give back. Paying more requires the buyer at exit to accept a materially lower yield
  than the one being paid today.

Each of those is arguable. None of them is free. Writing them down as the
conditions attached to a higher price is a more useful committee document than
either a flat rejection or a model quietly tuned until it cleared.

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*Illustrative teaching case. Northgate Commons, the market, the broker, the lender, the comparables, and every figure in this packet are fabricated for instruction. Nothing here is a real property, a real transaction, or a real financing quote.*