17
March | April | 2016 CCIM.com
Property A Property B
Gross potential rent $1,595,745 $2,659,574
Vacancy (6.0%) $95,745 $159,574
Effective gross income $1,500,000 100.0% $2,500,000 100.0%
Operating expenses $500,000 33.3% $1,500,000 60.0%
Net operating income $1,000,000 66.7% $1,000,000 40.0%
Debt service $761,955 $761,955
Net cash fl ow $238,045 $238,045
A at the end of the holding period, less 3.0
percent for transaction costs, is $17,735,325
using a terminal cap rate of 6.5 percent, while
the value of Property B is $15,540,850 (also
using a 6.5 percent terminal cap rate) — a
dif erence of almost $2,200,000. Obviously,
ref nance risk at the end of 10 years is mark-
edly less for Property A than for Property B.
Lastly the leveraged pre-tax internal rate of
return for Property A is 14.7 percent versus
an IRR of 10.4 percent for Property B.
T e analysis above is purely "by the num-
bers" and, by definition, does not include
non-quantitative factors. While the slightly
higher annual growth rate in operating
expenses attempts to take into account the
uncertainty regarding the stability of utility
costs for a master-metered property, spikes
in utility costs would have a dramatic impact
on the performance of Property B. As a result,
the predictability of Property B's cash f ows
is much more dif cult to assess. Uncertainty
is risk and a transaction with enhanced risk
should be modeled to generate a higher IRR
to an investor. However, as the analysis shows,
when the same dollar amount is paid for Prop-
erty A and Property B, Property B actually
yields a lower return — not the higher return
that investors should expect.
As this simple example illustrates, inves-
tors need to be wary of purchasing multifam-
ily projects based solely on going-in cap rate
analysis. T e performance of various acquisi-
tion targets needs to be analyzed with a focus
on operating expense ratios, the allocation
of utility costs, and realistic projections for
annual rent and expense escalations. Multi-
family properties should be modeled over a
10-year holding period to test assumptions
and make informed determinations about the
value of the future benef ts being purchased.
David L. Church, CCIM, is managing director
at U.S. Realty Capital, LLC. Contact him at
dchurch@usrealtycapital.com. A version of this
article fi rst appeared in the Mid-Atlantic Real
Estate Journal.
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