This chapter is the first of two covering the fundamentals of underwriting a potential real estate transaction. In the underwriting process, an investor makes assumptions about a property’s likely future performance–as well as the investment required to get there–to decide whether or not it’s a good deal worth pursuing.

While real estate investors use a number of metrics to evaluate deals, this course focuses on the two most important: Unlevered Yield-On-Cost (UYOC) and Internal Rate of Return (IRR). First, let’s tackle UYOC.

UYOC is the simplest of the two metrics, as it is a “snapshot in time” measure. A project’s capital structure–including debt–doesn’t have any impact on unlevered yield. UYOC is calculated by dividing a project’s stabilized NOI by its all-in cost:

Let’s look at each of these:

NOI is the project’s annual profit. (It’s a bit more complicated than “cash flow”, we’ll get to that later on.) For value-add and opportunistic projects like Harbor Yards, NOI is calculated upon stabilization of the asset–that is, after any renovations and lease-up have been completed.

Total Cost is the sum of all costs required to complete the project, including the initial purchase price as well as any hard costs and soft costs accrued during the project.

To underwrite a deal, we’ll need to estimate both of these numbers.

Underwriting NOI requires making estimates around both project-level revenue and expenses. In a real estate project, rent will typically be the largest component of revenue. Most real estate developers estimate rent by looking at comparable assets (“comps”) in the area. Of course, no perfect comp exists, so comps are typically adjusted based on their location and quality to arrive at a underwritten rents.

That said, a project’s estimated rents should diverge too wildly from comps. If nearby comparable retail spaces are renting for $50 per square foot, an analyst should have a very good reason to estimate a significantly different rent for his or her project!

Analysts may also choose to “trend” their rents by assuming some year-over-year rent growth in the model. This is particularly relevant to ground-up developments which may take several years to deliver, at which time rents may be much higher than they are today. Trending rents at 2-4% per year is generally considered reasonable; investors should beware of deals that use higher numbers!

Expenses are underwritten in much the same way but can have more variability project-to-project, and some expenses can be difficult for inexperienced developers to accurately estimate. Typical major expense lines for a commercial real estate project include:

• Utilities
• Repairs & Maintenance
• Janitorial
• Security
• Contract Services
• Leasing & Marketing
• Insurance
• Technology
• Property Taxes
• Property Management
• Reserves

Note that a property may have some cash expenses–such as major capital improvements and one-time leasing commissions–that are not counted as building expenses for the purposes of calculating NOI.  Similarly, the building may have some non-cash expenses (such as reserves) that are taken into account when calculating NOI.

Subtracting underwritten expenses from revenue yields NOI, the numerator of the Unlevered Yield on Cost calculation.

The UYOC denominator–total project cost–is the sum of two things:

Initial purchase price, which is exactly what it sounds like–the price paid for the land or existing asset.

Development cost, or the sum of all money spent to reach stabilization. This includes both hard costs (labor and construction materials) as well as soft costs (architectural fees, permitting costs, and other expenses).

Dividing NOI by total project cost is a deal’s underwritten UYOC.

When underwriting in practice, the initial purchase price often becomes the variable in this equation. Through underwriting, a developer will establish a good sense of a project’s likely NOI as well as development cost.  The developer also knows the UYOC they likely have to hit to make the project’s viable in the eyes of investors. The initial purchase price is the variable, and the UYOC equation tells a developer what price they have to hit to make a deal work.

But since UYOC is a “snapshot in time”, it doesn’t give a developer a good sense of the return they’ll generate for their investors. A project will generate the same UYOC whether it takes two years or twenty years to complete. But for investors, a faster return is obviously better.

The timing of this return is taken into account when calculating internal rate of return (IRR), which we’ll cover in the next section.

– Brad Hargreaves

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