When you’re looking to invest in a multifamily deal, it’s vital that you’re able to underwrite a deal properly and conservatively. Underwriting refers to analyzing a property’s past and present performance and forecasting future performance to determine the value of that property and understand the associated risks. What I mean by being able to underwrite a deal “conservatively” is that you forecast the financials in a way that incorporates a margin of safety so that if the operations of the property were to go south, your investment is still intact from a return standpoint.
Something important to note is that you need to have an understanding of what returns you are aiming for and if they’re reasonable when underwriting. Most deals will not pencil out when you run the financials and knowing what you’re looking for will help when there is a deal that looks interesting. There is no need to force a deal to meet your returns. If you do force a deal to fit your investment criteria, you run the risk of having very little wiggle room if or when things do go wrong. At the end of the day, you want to be confident that your investment will play out the way that you want it to. In this post, I want to outline three tips that we at JP Acquisitions incorporate into our underwriting so that we feel confident we can meet our investment returns. The last thing we want to do is underperform and not hit the targets we set for our investors.
Expenses
The first tip I want to bring up is in regard to expenses. When you get the offering memorandum (the investment package) of a deal, you will see the historical expenses of the property and the projected expenses of the broker. You’ll want to plug in the historical expenses into your underwriting model so that you see how the property has performed in the past. From there, you’ll want to compare those expenses to how you think the property will operate. Expenses trend differently depending on the area, but the point is that you never want to simply assume that the property will continue to run at what it has historically. A good rule of thumb is to bump up expenses to 50% of the annual gross income, if it isn’t there already, and see if the deal still works out. While 50% expenses seem unrealistic to underwrite to, you can rest assured that if the deal still pencils out at 50% expenses you are looking into a property that could potentially be a good deal.
On a line-by-line basis, insurance and taxes are the two things that are guaranteed to jump up significantly. Taxes will be adjusted based on the purchase price and as a result, are bound to go up. As a rule of thumb, accounting for a 20% increase in property taxes is conservative. Insurance expenses, on the other hand, have gone up tremendously and we typically factor in double of what insurance had been historically. I recently spoke to a loan officer who confirmed that doubling insurance is a conservative way of underwriting. After accounting for those two line items, you’ll want to bump up the utility expenses by at least 10-15%. In terms of management fees, if you choose to hire a property management company, you’ll want to contact property management companies in the area to get an idea of what percentage of gross rental income they’ll charge to factor into your financial model. All other line items require your judgment based on real estate professionals you’ve spoken with, prior experience, and your understanding of the market. Some of the line items I’m alluding to include advertising, contract services, general/admin, legal, payroll, repairs and maintenance, and turnover expenses.
Exit Capitalization rate
The exit cap rate (also referred to as the terminal cap rate or the reversion cap rate) is one of the most sensitive inputs in any underwriting model. This input will guide what cash you can pull out of your deal at refinance and the value of your property upon sale/disposition. At JP Acquisitions, we like to factor in an exit cap rate that is 50 basis points (0.50%) higher than the cap rate at which we purchased the property at. By doing this, we take into account a comfortable cap rate that factors in a downside scenario if interest rates were to rise in addition to other factors that could negatively impact the deal’s returns. If you factor in the same cap rate that you bought the property at as an exit cap rate, you run the risk of being disappointed of the cash you can pull out at refinance and the sale price down the road. As a matter of fact, we’ve set our model to automatically factor in a 50 basis point increase in the exit cap rate to make sure that we’re being conservative.
As an example, let’s say I bought a property doing $50,000 in net operating income (gross rental income – expenses) at a 6% cap rate. That means I would have bought the property for $833K. Over the course of time, I increased the net operating income (NOI) by $10,000, but interest rates increased by 2% during that time. It is likely that cap rates would have increased in the area and thus the 6% cap I bought the property at is likely to no longer be applicable. As a result, since I didn’t account for an increase in the cap rate in my model when I bought the property, I would be disappointed to see that the new cap rate is 6.5% or higher. A property doing $60,000 ($50K + $10K) in NOI at a 6% cap rate would be valued at $1MM. A property doing $60,000 in NOI at a 6.5% cap rate would be valued at $923K. That difference amounts to $77,000 and will completely change the returns of the deal. This example clearly lays out how what might be a seemingly small difference in the exit cap rate can change the economies of a property.
Debt Terms
The final underwriting tip I want to mention has to do with debt terms. One of the biggest factors that impact a deal in addition to the exit cap rate is debt. When underwriting a deal you’ll want to factor in the most undesirable, yet realistic, debt terms to see if the deal will work. If you have a loan officer or bank that you regularly work with, you’ll want to give them the financials of the property you’re underwriting so that they can give you a range of debt terms that seems realistic. As you gain experience you’ll get a feel for what terms to incorporate into your underwriting, but if you’re just starting off that may be difficult. As an example, I recently underwrote a deal in which based on prior experience I knew it was conservative to factor in a 6.6% interest rate with 25 years of amortization and a down payment of 25%. The deal still worked given those figures and I contacted the loan officer we regularly work with to confirm if I was being conservative. He stated that we’ll likely land in the ballpark of a 6.25% interest rate with 30 years of amortization and a 25% down payment. In addition, he confirmed that the debt I was factoring into our underwriting was realistic and we’ll want to keep those terms factored in as we continue to underwrite the deal. At the end of the day, paying attention to the debt market is key when underwriting and you never want to be in the position of getting a deal under contract having assumed that you’ll get amazing debt on the property.
Conclusion
Being able to underwrite conservatively cannot be stressed enough in the world of real estate. Investors need to be realistic in their assumptions and factor in room for error so that they can meet returns if the operations of a property were to be negatively impacted. You should never simply assume the broker’s assumptions into your underwriting because more often than not they paint a rather rosy picture. The projected expenses in your underwriting model, at least in year one, need to be higher than what the property performed historically to account for unknown factors. The exit cap you factor into your model should always be higher than what the going-in cap rate was. When it comes to debt, you’ll want to factor in terms that are undesirable, yet realistic, so that you’re not surprised when it comes time to purchase the property. In essence, these tips for underwriting are ways to stress test your deal. When you factor in all these tips when underwriting, chances are that you’ll “break” the deal. As you move forward in the due diligence process things will change and the new knowledge you gain will need to be incorporated. By no means am I suggesting that if the deal doesn’t pencil out after factoring all these tips then it’s a bad deal. I’m simply suggesting that you should see where the deal you’re looking into lands given the tips I’ve suggested in this blog post. Individuals that are reading this who have experience may be rolling their eyes and thinking that no property will ever work after factoring all these tips. To that I say that you should always use your own judgment given what you know about the deal at hand and the market you’re in. This blog post simply provides some tips that we use at JP Acquisitions to stress potential deals in order to make sure they’re worth the investment.
If you have any questions regarding the terms and concepts in this post or previous ones, don’t hesitate to reach out to either me (tedi.nati@jpacq.com) or someone on our team so we can help explain what is causing the confusion. If you’re interested in investing with us at JP Acquisitions, you can contact us via email (contact@jpacq.com), LinkedIn, Instagram, or our investor portal to set up a meeting.
As always, I hope you enjoyed reading this post as much as I have writing it. Best of luck!
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About the Author
Tedi Nati is the Managing Partner of JP Acquisitions. In his role he is responsible for broker outreach, establishing deal flow, underwriting, marketing, and assisting in the closing process. In addition to his role at JP Acquisitions, he is an Assistant Equity Underwriter at Cinnaire, a non-profit Community Development Financial Institution (CFDI). In his role at Cinnaire, he is responsible for assisting the underwriting team in evaluating and structuring real estate equity investments and assessing the risks and mitigants associated with such. Tedi earned his Bachelor of Science in Finance from DePaul University, where he graduated Summa Cum Laude. In his free time he enjoys reading, writing for his blog (tedinvests.com), looking for multifamily deals, working out, and researching stocks.
Make sure to always do your own research before making any final decisions on buying/investing real estate, stocks, or other securities. I am not a CPA, attorney, insurance, or financial adviser and the information in this blog post shall not be construed as tax, legal, insurance, construction, engineering, health and safety, electrical or financial advice. If stocks or companies are mentioned, I sometimes have an ownership interest in them – DO NOT make buying or selling decisions based on my posts alone. If you need such advice, please contact a qualified CPA, attorney, insurance agent, contractor/electrician/engineer/etc. or financial adviser.
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