Architect As Developer: 04
04: Proforma Lingo — For Rent Projects
This is Part:04 of the AAD Series. Check out Part:03 if you haven’t already.
Ok, so you’ve already gone through some of the terms for the For Sale proformas, and now it’s time to get into the proformas that you’ll need if you’re developing something that you intend to hold. I will admit right here, I’m a “build and sell” guy, so For Rent proformas are not my strength, but I do know enough about them to feel quite comfortable writing this.
For Rent Proformas
A few of the terms discussed in the creation of a For Sale proforma, such as Total Development Cost, Hard Costs, and Soft Costs are the same here. There are other terms however, which are unique to For Rent Proformas.
Again, this may be basic to some, but I want to start with a solid foundation as I’ve said before. So for all you salty dogs out there, don’t hate me, just hang in there.
Key Terms Used For Analyzing The Development
Revenue or Gross Potential Income
This is the money you could potentially collect on rents, leases, etc from the property you own, if it were all leased up at the rents you would like. It could even include a billboard you rent out for advertising on the roof. If someone is paying you for using or doing something on your property, charge them and count that money here. One thing you do deduct for is called the Vacancy Rate.
Vacancy Rate
Let’s face it, people, or businesses, will be moving in and out of your property. You won’t collect 100% rents 100% of the time. You have to account for that. Most people use a 5% vacancy rate for apartments, let’s say., but for your development that number may be different. You deduct vacancy rate from the Revenue number to get…
Gross Income
This is the income you expect to make every year; taking into account vacancies that occur now and then.
Expenses or Operating Expenses
This is what you pay to own and operate your property. This can be a host of things, and they are unique to the kind of property you own, but they include things like:
- Admin Costs
- Maintenance
- Taxes
- Insurance
- Management Fees
Note: Operating Expenses should not exceed 25% — 30% of your Gross Income. Banks don’t like that and it means you’re running your property inefficiently. That might make you look good to other devleopers looking for “value-add” properties (another subject altogether).
Net Operating Income (NOI)
In the most basic terms, this is what Income is left after you deduct Expenses from your Revenue. This is a very important number, because you use it in conjunction with the Cap Rate to figure out all kinds of stuff, primarily, how much your project is worth. That value, in turn, is used to figure out how much of a Perm Loan you can get. More on those terms next.
Capitalization Rate or Cap Rate
Ah the Cap Rate. (Get some coffee, this may take a while.)
This number is very important, but everyone has a different one and honestly, no one really knows what it is. Actually, that’s not true either, let me explain.
Wikipedia defines cap rate as “a real estate valuation measure used to compare different real estate investments. Although there are many variations, a cap rate is often calculated as the ratio between the net operating income produced by an asset and the original capital cost (the price paid to buy the asset) or alternatively its current market value.”
So, there you are. A ratio between NOI and current market value. You divide the NOI by the current market value to arrive at the cap rate.
Here’s the issue, everyone has a different market value for a property. Sellers always think their property’s value is high. Buyers always set the value of a property they’re looking to buy, low. Developers, like you, think their property is going to be the next best thing since sliced bread so they always project their value to be high. You see what happens, everyone is setting a different current market value and therefore, everyone will arrive at a different cap rate.
How does this come into play with a rental property development?
Well, if you’re going to develop a rental property, you’re going to need money, or equity. You’re going to need to buy the land; you’re going to hire consultants, architects, engineers, interior designers, blah, blah, blah. Then you have to pay for the construction itself!
Then one day, 12 months later let’s say, your property is standing, shining beautifully and galantly in the mid-day sun, and you have $3M in loans to pay! How will you do that? You’re not selling the property so it’s not like you can sell it for $4M and then pay back your loans and keep a little profit. No, this is a “hold” investment.
“But I need to pay all those people!” you say.
Well, you’re going to have to take out a loan, or more precisely, a Permanent Loan, or Perm Loan.
Perm Loan
This is often referred to as a “take out” loan, because it “takes those other lenders out” of the deal (and off your back). Usually, they’re 15 year loans.
Hint: If you’re up to it, get a Perm Loan where the first 5 years are interest only, therefore getting lower monthly payments, and then sell your property at the 5 year mark. You paid little, but gained much. Just a thought.
Question, how does this new bank make this loan without knowing the “value” of your new property? For example, if you’re buying a house, it’s on sale for $500,000, you go out and get a loan for that amount. But here, you’re not selling your property, you’re keeping it, but you’ve got to assign it a value. How much is it worth?
This is where the Cap Rate comes in (and where the arguments begin). What most people do is “pick” a cap rate based on historical data of similar properties around them. Then they take the NOI divide it by cap rate, and you get your value. Examples:
NOI = $250,000 / year
Cap = 5%
Value = $5,000,000
NOI = $250,000 / year
Cap = 6%
Value = $4,166,666
Notice that as the cap rate goes up, your property’s value goes down.
A-ha moment #1: Banks always use high cap rates…or at least higher than your number, when making a Perm Loan. Go figure.
A-ha moment #2: Don’t use low cap rates on your proforma to make it “work” better!! You’ll fool yourself into thinking your project is more kick-ass than it really is. Be realistic.
Debt Service
This is the amount of money you need to pay every month to “service” the Perm Loan. Think of it as a mortgage payment.
Debt Coverage Ratio (DCR)
This is a ratio between your monthly Debt Service and your monthly NOI. It tries to show what how much your property earns per year in relation to how much you have to pay in debt payments every year. Banks like to see ratios of 1.2 and up most of the time; it varies. A 1.2 DCR means you’re earning 20% more per year than you need to cover the loan payments. In general, the higher the DCR, the better.
Key Terms Your Investors Will Use in Analyzing Deal
Internal Rate of Return (IRR)
This is definition is a bit basic, I will admit that up front. But it’s how I like to view it and use it for my purposes. I like to keep it simple. You can find a boatload of posts on the internet that go into this in more detail. But for our purposes, the IRR is the rate of profitability of a development over time. Just think of it as a return like any other interest rate. It’s more than that, but again, I like things simple. This will become clearer when we get into the proforma.
Cash On Cash
This is the rate of return when you specifically compare just the cash that the investor put into the deal with how much profit, or “cash”, they’ll get at the end. This is usually calculated before taxes.
Final Thoughts
As I said up top, For Rent proformas are not my bread and butter and I’m sure experts and veterans of rental deals will have comments and things to say like, “Dude, you totally forgot…x…y…and z.” No argument from me. My opinion is just keep it simple. When you need to get more into the weeds, do so at that time.
Next Post:
05: Rental Proforma — Walkthrough
Next I will walk you through a rental proforma. That will take several posts as there is a lot to cover, but I will do my best to give you as much detail as I can while still keeping it concise and digestible.
Do you have questions?
I want to answer everyone’s questions as best I can given my other responsibilities (don’t forget, I have a firm and office to run). Please post your questions below and I’ll try and answer them as best I can.
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