Underwrite Conservatively by Focusing on these 5 Components
Investors, either passive or active, should always keep an eye out for conservative underwriting when they are evaluating deals. This is an important practice to maintain no matter where the real estate cycle is at. The goal for investing is to make money not lose it. You can mitigate that risk right from the very beginning by underwriting with very conservative numbers. Whether you are investing by yourself or have 30 investors in a large syndication, no one will ever be mad if the returns come in higher than projected. As Warren Buffet says, “Rule No.1: Never lose money. Rule No. 2: Never forget rule No. 1.” In this article I will cover 5 key ways to conservatively underwrite a property. (1) Rent Growth: When underwriting a deal, an investor will build in an annual rent increase, usually between 1% to 5%. On average, the annual increase used is around 3%. To make sure that the property is underwritten conservatively, it is best to assume 0% to 1% for rent increases within the first year or so. This is essentially saying that the current income in place at the time the property is purchased will remain flat for the first year. This is conservative but necessary because the economy can shift & unforeseen situations may occur. This may cause pricing to flatten out for a period. Play it smart and assume little to no price increase within the first year or so. Another example is when an investor has the goal to take current rent and increase it to market rates. This would be possible if there were multiple units with outdated interiors. By updating these units with new flooring, appliances, and paint, then rents could increase by $150 per month to market levels. To conservatively underwrite this scenario, it would be best to assume that market rents will not be achieved within the first 12 to 18 months. Instead, assume that market rents will be achieved after 2 – 3 years of holding the property. (2) Vacancy: When discussing vacancy, investors need to assume both physical as well as economic vacancy. Physical vacancy being a tenant is not occupying a unit while economic is bad debt or concessions. Bad debt is when tenants fail to pay their rent and that money is never collected while concessions are promotions to help lease up units. Examples of this could be a free month of rent or free parking for 6 months. To make sure that the underwriting is done in a conservative fashion, it is best to increase the vacancy rate (Physical only) from 3% - 5% up to 10% - 12% which accounts for both physical and economic vacancy. (3) Expenses: In almost all pro formas the income will be overstated while the expenses are understated. We covered the income portion above so now it is time to discuss what conservative expenses look like. A great indicator to see if the total expenses are conservative is by looking at the expense ratio. This is comparing the total operating expenses to the total net income (Gross income minus vacancy). A conservative expense ratio is anywhere between 50% to 60%. Although the building may operate at a lower expense ratio, it is important to make sure that the underwriting assumes higher expenses. (4) Replacement Reserves: Owning a property means that there may be some big-ticket items that will need to be replaced. This could include a new parking lot, roof, or all new plumbing. These items are called capital expenditures. To make sure we can afford these items, it is important to keep a portion of the income as replacement reserves/CapEx Reserves. The rule of thumb is $250 - $300/per unit/per year. Another piece to this that ensures that the underwriting is conservative is that we account for this as an operating expense. Since this is not a proper operating (day-to-day) expense the liberal practice is to add this as an expense after the NOI just like we do with debt (Below the line). By accounting for this (above the line) that means that it reduces the NOI. The reason this is conservative is because in the underwriting we are forecasting a sale price at the end of the holding period. Since we have underwritten a lower NOI this will result in a lower sale price since (NOI / Cap Rate = Price). The lower sale price will then lower the projected returns on the investment. If the returns look good with this conservative underwriting, then the odds are that the investors will receive even greater returns than projected. (5) Exit Cap Rate: The exit cap rate (Capitalization Rate) is a very important piece that can be easily overlooked. It is important to note once more that the price of the property equals NOI / Cap Rate. That means that if we hold the NOI fixed then a lower Cap rate would increase the value while a higher cap rate would lower it. With that being said, let’s say we buy a property at a 6% Cap rate and sell it in 5 years. To conservatively underwrite the sale price at the end of 5 years it is a good rule of thumb to increase the Cap rate by 10 basis points per year. That means that the Cap rate would be 6.5% at the time of the disposition. Again, when the sale of the property takes place, the Cap rates may have stayed the same, only gone up 20 basis points, or maybe even gone down. This is good because that would mean our gains would be even greater than we had predicted. Conclusion: Overall, the goal is to achieve solid returns with conservative underwriting. What will most likely happen is a situation where you end up realizing higher returns than what was forecasted. Whether you are an active or passive investor make sure the underwriting is sound and conservative. You will be thankful you did!