Underwrite Northgate Commons

Illustrative teaching case. Northgate Commons, the lender, the broker, and every figure below are fabricated for instruction. This is a model of how a memo reads, not a real recommendation on a real asset.

Recommendation

Proceed at a revised price of approximately $17,000,000, which is $400,000 and 2.3% below guidance. At the asking price of $17,400,000 the deal returns 13.42% levered against our 15.0% hurdle, so it does not clear as offered.

The deal

How we got to net operating income

Where our number differs from the broker's

The offering memorandum presents year-one net operating income of $1,469,615 against our $1,090,004, a difference of $379,611. The itemized differences follow. They do not foot exactly to that total, because the vacancy item is measured against a single illustrative factor while our year one uses actual trailing vacancy, concessions, and credit loss, and a bridge between two differently constructed statements that does foot to the penny is usually one where the difference was plugged.

• Rent growth of 4.5% applied to market rents$91,087

  The market survey supplied in the package forecasts 2.8% for the next twelve months and the last twelve months ran 3.1%. Underwriting year one off the trailing twelve months applies no forward growth at all.

• Vacancy factor of 4.0%$60,777

  The submarket survey shows 6.0% and the property's own trailing twelve months ran higher once concessions and credit loss are counted. A 4.0% factor is below both.

• No management fee anywhere in the expense load$55,950

  The seller self-manages. A buyer pays a third-party manager, and the lender underwrites one whether or not the buyer intends to self-manage.

• Property taxes held at the seller assessed value$122,958

  The county reassesses to roughly 92% of the recorded sale price in the tax year after a transfer. The seller has held since 2009.

• No replacement reserves$36,000

  A 1986 asset needs an ongoing capital allowance. The term sheet escrows $300 per unit per year, so the reserve is a cash cost regardless of how the pro forma presents it.

Financing

Proceeds of $10,634,000 are governed by the minimum debt yield of 10.25%, which sizes $676,000 below the loan to value test and $1,044,361 below the coverage test. Running only the two familiar tests would over-lever this asset. At the resulting loan the deal carries 61.11% leverage and 1.37x coverage on the fully amortizing constant. Because debt yield is the binding test, proceeds move in direct proportion to net operating income: a five percent miss on year one moves the loan by roughly $532,000.

The business plan

The plan is an interior renovation program rather than a repositioning. 18 of the 120 units have been renovated by the seller, which leaves 102. We underwrite 34 units a year for 3 years at $9,500 a unit, so the program covers 102 units and $969,000 of capital, spent at $323,000 a year in years one through three. That capital sits below net operating income and is separate from the $300 a unit replacement reserve already inside the expense line, which covers the building rather than the unit interiors.

The premium is the part worth arguing about. The plan sheet carries $150 to $175 a month of renovated premium depending on plan, which blends to roughly $160 across the 102 units still to be touched. On a $9,500 spend that is about 20% return on cost before any allowance for downtime on turn. Together with the burn-off of loss to lease it is also a large part of why effective gross income is underwritten to grow 6.0% in year two and 5.5% in year three before stepping down to 3.0% once the program is finished.

The rent comparables support that premium in absolute rent more than they support it per square foot. Maple Grove Flats, renovated and built 1991, achieves $1,735 on a two-bedroom against $1,510 at Preston Landing, which is classic, so the spread between a renovated and a classic two-bedroom across those two properties is about $225 and the $175 we underwrite sits inside it. Per square foot the reading is less comfortable. Our renovated 2BR / 2BA plan asks $1.64 a foot against $1.59 at the renovated two-bedroom comparable, and our renovated 1BR / 1BA plan asks $1.91 against $1.78 at Chandler Row, the stronger of the renovated one-bedroom comparables. Those two plans are 70% of the property, so the program is underwritten to price at the top of its plan type rather than in the middle of it.

That is a defensible place to sit for a 1986 vintage after a $9,500 interior, and it is not free. The evidence behind it is 18 finished units, which is a thin sample to carry a program of this size. The control we would want is the first year's 34 units priced and leased before the back half of the budget is committed. Slowing the program is available if the premium comes in light, because renovation capital sits below net operating income and therefore outside the minimum debt yield of 10.25% that sizes the loan.

What we are underwriting that we do not know

• The exit cap. The deal returns most of its money at sale, so five years of cap rate movement drives more of the answer than the operations do. Widening the exit assumption by 25 basis points reduces the levered return by more than a full point.
• The renovation premium holding. 18 units have been renovated. That is a small sample from which to conclude the premium repeats across the remaining 102.
• The pace of loss-to-lease capture. We underwrite none of it in year one, which is conservative. Leases roll across twelve months, so a case can be made for capturing part of it, and that case is worth more than it looks because it lifts the year being capitalized at exit as well as the years in between.

Recommendation detail

Solving the model for the hurdle puts the clearing price near $17,000,000, or $141,667 per unit. A small price move does a surprising amount of work here, because a lower price means both a smaller equity check and a lower reassessed tax bill, and the two effects run the same direction. We would pay closer to guidance only against evidence on the three assumptions above, in particular a leasing plan that captures part of the loss to lease in year one and rent comparables that support the renovated rents across the untouched units. 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.