Guest Post – Difference in Underwriting From a Buyers and Sellers Perspective

By: Jon, with input from the team at www.argusvaluation.com

In our first guest post, we explained The Role of the Real Estate Financial Analyst.  In today’s post we’re going to get a bit more specific and explain how someone who receives an Argus projection on the buy-side should approach auditing the assumptions in the projection.

Even though it is common knowledge that sell side analysts underwrite their models with assumptions to enhance net operating income (NOI), many buy side analysts miss out on common subtleties which can lead to a more accurate view of NOI over a 10-year period.

In this post, the 5 main topics discussed will be:

1. Management Fees
2. Structural Reserve
3. Reimbursement (are tenants really triple-net?)
4. General Vacancy Rate / Credit & Collection Loss and exclusions
5. Market Leasing Assumptions

1.  Management fees are impacted by several issues:

• They get projected at rates of anywhere from 1%-5%
• They also are sometimes a percentage of base rent and other times a percentage of effective gross revenue
• And if you weren’t confused enough yet, they also get listed as reimbursable or non-reimbursable expenses.

The trick with management fees on the buy-side is to take things with a grain of salt.  Obviously during your firm’s ownership of the property, the expense will be different depending on if you manage it in-house or hire a third-party management company.  Typically an industry standard amount to use is 4% of effective gross revenue, and place it within the Non-Reimbursable Expenses category.

Often times Argus files you will receive will show that management fees are being recovered by tenants, and we caution you to verify this with tenant leases during due diligence because often times this isn’t actually the case.

2.  Structural reserve is a pretty simple issue.  Typically it is categorized as a Capital Expenditure, although sometimes your principal may ask you to move it under Non-Reimbursable expenses so that it is above the line (i.e., decreases NOI to reduce pricing, and not just cash flow).  Typically you’ll find the expense in the $0.10 per square foot range for a property, although you’ll want to increase this amount to $0.15-$0.20 per square foot depending on the age and condition of a property.

3.  The issue we bring up regarding tenant reimbursement is more general in nature.  Especially in retail properties, one must be careful to consider that the Argus projection is accurately taking into account tenant reimbursements and not overestimating the amount of expenses recovered.  Often, sell-side analysts will prepare an Argus projection and assume all tenants reimburse full pass-throughs, however in reality this is rarely the case.  Many tenants often have restrictions on certain expenses, others such as anchors often pay small fixed amounts, while sometimes even retail tenants may be on gross leases.

By running a property report and comparing the overall reimbursement revenue versus the operating expenses one can get a good sense of the percent of overall reimbursement and see if it makes sense relative to the property type and tenancy.

4.  General Vacancy Rate and Credit & Collection Loss is a way to project a market vacancy factor and reduce the potential gross revenue derived from your projections in Argus.  This amount differs depending on the market, and can be anywhere from 5% to 20%.  One must be diligent in their market research to find averages for the marketplace in comparable properties, as underwriting with too low a rate will lead you to pay too high a price given the income at the property.

Something else to consider is to check over any tenant groups excluded from the vacancy factor.  Large anchor tenants and other national credit tenants often can safely be excluded from this revenue deduction as they are typically not going to suddenly leave the property.  However, the case could be made to include even a national grocer like Kroger if there is little time left on the initial lease term.  The important point here is to review all exclusions listed and make sure that you are confident in them remaining at the property.

5.  Market Leasing Assumptions (MLA’s) are typically what drive most of the revenue growth in an Argus projection.  This is because this is where market rents come into play as leases expire.  All MLA’s need to be thoroughly scrubbed to ensure conservative market rents are projected, along with all of the other rollover assumptions such as vacancy before the space is re-leased, anticipated abatements, and tenant improvement expenses.  By carefully reviewing tenant MLA’s and ensuring that no tenant jumps in rent from for instance an $8.00 per square foot gross rent to $15.00 per square foot triple-net rent without a reason which the seller can confidently backup, you protect yourself and help to ensure you aren’t met with major surprises during the life of an investment.

These five items are helpful to review each time you receive an Argus model for a property, and by carefully auditing the work given to you, you will hopefully be aware of the true returns potential for a property.

The main software we discussed today was Argus Valuation DCF.  It is integral to an analyst’s daily responsibilities, and one must be comfortable with it to ensure that all projections for a property are handled properly.  If you’re not familiar with Argus, visit www.argusvaluation.com or email us at argusvaluation@gmail.com to learn more about the training courses we offer.  Also, if you have any general questions about this post please feel free to email us.  Good luck in your real estate career.

Similar Posts:

• Guest Post: The Role of the Real Estate Financial Analyst
• Argus Certification Exam: What To Expect and How To Prepare
• Builders Corner: Financing Out

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