Curious to understand how you guys calculate NOI at sale for a multifamily deal. I have seen three views on this and would like to better understand how others determine terminal value NOI on a deal since you acquire deals using T1 to T3 revenue and Full year expenses for NOI. In the scenario below, assume property will be sold at the end of year 5.
The methodology used can have an impact on NOI as most folks assume T3 revenue annualized and FY expenses.
Which of the following is the most logical for terminval value:
- Option 1: Year 6 NOI in the model
- Option 2: Year 5 NOI in the model
- Option 3: Year 6 NOI, period 12 annualized revenue and full year expenses (essential last month of Year 6 annualized EGI less FY revenue to determine value)
- Option 4: Year 6 NOI, period 10-12 annualized revenue and full year expenses (essentially T3 revenue)
- Option 5: Year 5 NOI, period 12 annualized revenue and full year expenses
- Option 6: Year 5 NOI, period 10-12 annualized revenue and full year expenses (essentially T3 revenue)
Thanks in advance and if you feel one option is best, please state the "WHY". If you recommend a different methodology, please share as well. I am taking into account vacancy, loss to lease, etc in all scenarios. Just curious about what valuation methodology makes sense as all impact terminal value and proforma returns IRR. Thanks!
Not to avoid a direct answer here but there is no most “logical” assumption here - all of the options you have laid out have different advantages and cases to be made depending upon how conservative you want to be but most importantly your assumptions.
For example if you are underwriting a value add/rehabilitation project so you are being really aggressive with your rental growth assumptions and find your IRR is being significantly impacted by your terminal event (more than usual) than run a matrix where you utilize the year 5 NOI versus the trended year 6 NOI and observe the impact on return.
That being said if your target is to closely replicate the truth your model should incorporate some element of seasonality. Most markets have a “lull” in the leasing season during winter so annualizing revenue in October through December will likely be too punitive relative to the year’s NOI.
Another important perspective for any seller to look at is how is a prospective buyer approaching this deal? Often we will run a mini 5 year model to see what return they could be chasing. This is all the more important in California as property’s taxable value doesn’t change until the building trades hands so we will often set the sale value as the new taxable value, apply the new Real Estate taxes to our predicted value then utilize the adjusted terminal year’s NOI to calculate the buyer’s going in capitalization rate.
It’s all dependent on the deal and you need to understand the trailing income and expenses to do this. On the acquisitions end, you are going to look at the latest rent roll and underwrite your rents at those levels. You also need to look at income and expense line items of the t12 and last 3 years and see if there are certain things that need to be normalized (a one time increase in income which might show up in a t12/same for expenses). Generally a broker will sanitize the numbers in the OM and write what they did in the notes to cash flow. You may find that revenue which the broker is underwriting has $60k of termination fees underwritten which you will need to take out of other income. What I’m trying to get at is you need to use the current rent roll and a mix of the historicals. On the sales end, there are methods that are defensible, however, the most common method would be the forward 12 income and expenses at a cap rate. Assuming you have rents grow by a certain amount per month (1/12 of the growth rate) you could use the top line number as rents that month. However, than it comes down to modeling policies. For instance, my shop underwrites rent growth occurring once per year while other shops grow rents monthly.
@puddling thanks for responding but you didn't answer the question asked. definitely use a logical approach when it comes to acquiring a property. my question is about "EXIT" in your proforma model for value add deal where the new buyer is going to be a CORE buyer once you have done the renovation.
if you are selling at the end of year 5, PROFORMA numbers for year 1 to 5 as well as 6!! most folks assume cap rates go up in the model by 25 to 50 basis points from acquisition cap rate vs disposition, maybe even more! the question is, what NOI do you use based on your proforma numbers. Since folks use T3 and full year expenses at the end of year 5.... my approach is to use full year 6 NOI to come up with value.
Thoughts?
I understand how to value a property, this is more about EXIT in a model which is proforma.
Thanks for responding! Hard to know who the seller will be because it's all proforma numbers. You are buying today and plan to sell in 5 years. It could even be a 3 year hold for value add deal. What NOI do you use?? Is it in place NOI using T3 for last three months of period you are selling annualized less expenses (model is a monthly compounding model along with full year expenses)? or would you use your full year 6 NOI as modeled? I assume a forecasted CPI growth rate on revenue and expenses at 2-3% so it's not an aggressive 7-10 growth.
thanks.
One thing that I am still unclear about is what is this sale assumption being used for - is it for a potential acquisition? A broker package or sale to another firm? A valuation to a bank for refinancing purposes?
Given that there is a spectrum of potential exit values depending upon your assumptions, you can change them as such depending on what you are trying to accomplish. If you want the value to be higher then utilize the year six NOI as it will have the rent increases likely baked in. If it’s a potential acquisition, I would be conservative and would utilize the actual 12 month trailing.
Additionally, I already commented on trailing three month - this is likely the wrong approach no matter what because it ignores seasonality.
Bottom line, there is no right answer. Assumptions can and should be tweaked depending on your objective, absolute rules are rare in underwriting (and life) and this is another example of that.
You can use any method you see fit, lender will re-underwrite and re-calculate NOI their ways
This isn't asking about the lender though. This is asking about a property trading hands.
If you’re selling to someone who needs debt to buy the property, you need to think of how the lender will underwrite.
You should also be comparing the methods used to determine the cap rate that you are using. If cap rates are quoted based on one NOI methodology, that is the one you want to use, otherwise you aren’t really comparing like income streams.
Applying a cap rate derived based on T12 NOI to a pro forma NOI when rents are rising faster than expenses will give you a higher value, while the opposite is true when expenses are outpacing income growth.
Hello, I usually do a multiresidential UW of (investment period +1)periods, thus I "cap" next year's NOI (in this case yr6). This is what I've seen from other investors also. If you do not have it available you can ask for an historical NOI, from there you can judge the seasonality effect and look at previous T4 vs T1-T3 etc..You can also take the last "full" year and inflate it a bit..
I believe this was already mentionned, but if you use T1-T3 and annualize it, I believe it to be "wrong" because of the fact that expenses and not evenly distributed across your model.
e.g. Visualize yourself trying to buy a larger building, think 250+ or senior housing, where you have a large staffing plan. On this blog, we speak a lot of our bonuses...they are mostly paid at the end of the year..thus this would impact your expenses and thus your NOI. OBV this is an example of one opex..but there are other seasonalities to others...Snow removal or others etc..
I also want to reiterate the point made in another post, where it mentionned not to underestimate the impact of the transaction on the tax assessment thus NOI thus value..
Another point is this building stabilized ? If not please consider lease up..and lease up adjustment when setting up your pricing..you want to normalize the NOI and cap it at at stabilized occupancy..
Hope this helps..you can DM for me info..
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