Below are some definitions that are used in this underwriting model1.
Assumptions Tab
- Acquisition/Development Cost – gross price (cost) of acquisition (development).
- Appreciation – an increase in the value of a property. In real estate, appreciation may be caused by inflation, demand pressures for land and buildings, a physical addition, modernization, removal of a negative factor from within or outside of a property, and sweat equity.
- Due Diligence/Closing Costs – due diligence costs such as inspections, appraisal, title, etc.
- Discount Rate – a compound interest rate used to convert expected future income into a present value.
- Loan Fee – cost of acquiring a mortgage.
- LTV – Loan to Value ratio.
- LTC – Loan to Cost ratio.
- Net Present Value – a method of determining whether expected performance of a proposed investment promises to be adequate.
- Preferred Equity Rate of Return – The rate of return required for the equity investor. Also known as the Discount Rate.
- Useful Life – in accounting and taxation, the period to depreciate a building.
Cash Flows Tab
- Effective Gross Income – Gross Potential Income less Vacancy and Collection Loss plus Miscellaneous Income.
- General Vacancy Rate – the percentage of space or units that are either unoccupied or not rented.
- Net Operating Income – income from property or business after operating expenses have been deducted, but before deducting income taxes and financing expenses (interest and/or principal).
- Cost Recovery Improvements – Estimated annual depreciation of the improvements.
- Loan Cost Amortization – Annual amortization of the loan fees.
- LCA = Loan Fee / Loan Term
- Taxable Income – Taxable Income is calculated as:
- TI = (NOI + Reserves) – (Interest Expense + Capital Expenditures + Cost Recovery Improvements + Loan Costs Amortization)
- Tax Liability – Taxable Income x Ordinary Income Marginal Tax rate (from Assumptions tab).
Summary Tab(s)
- Net Present Value (NPV) – A method of determining whether expected performance of a proposed investment promises to be adequate.
- Example: A proposed land investment required $10,000 of cash now and is expected to be resold for $25,000 in 4 years. For the risks involved, the investor seeks a 20% discount rate. The $25,000 amount to be received in four years, when discounted 20% annually, is worth $12,056 now. Since the investment costs $10,000 [now], the net present value is $2,056.
- Internal Rate of Return (IRR) – The true annual rate of earnings on an investment. Equates the value of cash returns with cash invested.
- Example: Abel sells for $200,000 land that he bought four years earlier for $100,000. There were no carrying charges or transaction costs. The Internal Rate of Return was about 19%. That is the annual rate at which compound interest must be paid for $100,000 to become $200,000 in four years.
- Example: Baker receives $3,000 per year for 5 years on a $10,000 investment. The internal rate of return was about 15%.
- Cash on Cash Return – Net Operating Income minus Debt Service divided by Equity invested.
Equity Investor Returns Tab
- Preferred Return (“Pref”) – a priority return on cash invested.
- Promote – an additional share of profits granted to the Sponsor above and beyond their pro-rata cash invested.
- Waterfall – a way of providing a successively larger Promote to the Sponsor the better the transaction performs. In this way the Sponsor has a financial incentive to pay close attention and strive to outperform for the life of the transaction.
1Jack P. Freidman and Jack C. Harris and J. Bruce Lindeman, Dictionary of Real Estate Terms 6th ed., Barron’s Educational Services, Inc., 2004 – (Find on Amazon)