Underwriting Games in Multifamily Deals: Cap Rates, IRR “Magic,” and Capital Stack Red Flags

I look at a lot of multifamily pitch decks, and almost every one has something off in the underwriting. That alone doesn’t disqualify a deal. What matters is whether you can spot the soft assumption and judge how far it moves the numbers. Below are the ones I see most often, with details changed because the decks are confidential.

The most common underwriting red flags in a multifamily syndication are an exit cap rate below the prevailing market rate, an early refinance that inflates IRR, a renovation budget that doesn’t match the projected rent increase, short-term debt, preferred equity ahead of common equity, and early distributions paid from reserves instead of operations.

Why small cap rate moves matter

By my estimate, multifamily cap rates are roughly a point and a half higher than they were a few years ago. That sounds minor, but it works out to something like a 20 to 30 percent drop in value. Common equity is usually about 20 percent of the capital in a deal, so a 10 percent change in property value is about a 50 percent change in the equity, in either direction. Every assumption below gets magnified by that leverage.

The refinance that inflates IRR

IRR rewards cash that comes back early. One deck I reviewed, a late-1990s B+ property, assumed a refinance in year three. Every operator hopes to refinance early, but a conservative model assumes no refinance and a sale in year five. Pulling refinance proceeds into year three puts a large sum near the front of the projection and lifts the IRR without changing anything about the property. If you are comparing two deals, check whether one of them only looks better because of this. Put both into your own spreadsheet with the refinance removed.

The exit cap rate below the market

In another deck the realistic exit range for that market and asset class was about 5.75 to 6.5 percent, and the model used 5.3. A lower exit cap rate means a higher sale price, so that single input can carry the whole projected return.

The comparison I care about is the exit cap rate against the prevailing cap rate, meaning what similar properties in that submarket are trading at today. The property’s own in-place cap rate is less useful because its financials are usually distorted, which is why someone is buying it. Conservative practice is an exit cap at or above the prevailing rate. A deck showing mid-fives going in and under four and a half coming out is assuming a stronger market at sale, and nobody in the deal controls where cap rates go.

Limited partners have a hard time finding the prevailing rate. It varies by submarket and asset class, and it isn’t published anywhere reliable. The best source is another operator active in that market who has no stake in the deal.

Rent bumps that don’t match the renovation budget

One deck planned a large capital budget with full interior renovations and projected rent increases under $100 a unit. Some investors read that as modest underwriting. I read it as a market where rents aren’t moving, and I wonder why anyone would spend that much for so little. Sometimes the budget is holding extra reserves because the sponsor expects a slow market. Ask what the renovation money is buying.

A related pitch is “we’re buying at a 30 percent discount to 2021.” That may be true, and it doesn’t tell you much. The useful question is whether today’s price plus the renovation spend produces enough additional net operating income to justify the project.

The loan terms

A fixed-rate, interest-only loan helps cash flow now, but prepayment penalties or yield maintenance can make an early sale expensive. Short floating or bridge loans carry a different risk. A loan described as three years is sometimes two years plus an extension the lender has to approve. If the market drops and the extension is denied, the owners may need to bring a lot of cash to refinance. Longer fixed terms reduce that risk and cost more.

Who else is in the capital stack

Preferred equity sitting between the bank and common equity gets paid first, often at a fixed rate well above the senior loan. When things go well, the leftovers go to common and the projected return rises. When cash is short, preferred takes what’s there and common gets less or nothing. Given two deals with the same projected return, I’d lean toward the one without preferred equity ahead of me. Side letters for larger investors can also change the order, so ask the sponsor to walk you through the full stack. Family offices ask this routinely.

Where distributions come from

Some sponsors raise extra capital up front and pay early distributions out of that reserve. If the offering documents disclose it, my understanding is it’s permitted, and reputable sponsors do it. It still means part of your early “cash flow” is your own money coming back. Check the debt service coverage ratio. Lenders generally want about 1.25. One deck showed a ratio near 0.5 while paying distributions, which told me operations weren’t covering the loan, let alone the payout.

Questions to ask on your next deck

What is the prevailing market cap rate, the property’s current cap rate, and the projected exit cap rate?
Does the projected return depend on cap rates falling?
Do the rent growth assumptions match the renovation plan?
Are the comps current, or taken from a different part of the cycle?
What is the break-even debt service coverage at exit, and how sensitive is the deal to the refinance rate?
Is there preferred equity or a side letter ahead of common equity?
Are early distributions funded by operations or reserves?

Frequently asked questions

What is an exit cap rate in a multifamily deal?

It is the cap rate the model assumes when the property is sold. A lower exit cap rate means a higher projected sale price. Conservative practice is an exit cap at or above the prevailing rate for similar properties in that submarket today.

Why does an early refinance raise the projected IRR?

IRR rewards cash that comes back early. Assuming a refinance in year three puts a large sum near the front of the projection and lifts the IRR without changing anything about the property. A conservative model assumes no refinance and a sale in year five.

What debt service coverage ratio do lenders look for?

Lenders generally want about 1.25. A ratio well under 1.0 means operations are not covering the loan payments.

Are distributions paid from reserves a problem?

If the offering documents disclose it, my understanding is it’s permitted, and reputable sponsors do it. It still means part of your early cash flow is your own money coming back, so check where the distributions are coming from.

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This is educational content, not tax, legal, or investment advice. We are not attorneys, CPAs, or financial planners. Examples are illustrative, with details changed. Please let us know if you need a referral to a CPA, lawyer, or other vendor here: https://thewealthelevator.com/vendor/