Conservation is the name of the game. Any “real estate professional” can say the investment property has great returns based on their underwriting, but how do you know their underwriting is accurate? How do you know they didn’t fluff the numbers to make the investment better than it is? More than likely it was not with malicious intent to fool investors, but the real estate environment is always changing and it is important to underwrite deals conservatively for market changes and unforeseen issues with the property. When you are investing your hard-earned income, it is important to know how the property was underwritten to mitigate risks and ensure you won’t lose money.
Underwriting is a term used to describe how real estate investors look at a property to see if the property is a good investment and determine the return metrics. The return metrics include: cash on cash, IRR (internal rate of return), AAR (annualized rate of return), and EMx (Equity Multiple). This is where the initial business plan for the property starts.
The biggest income-producing item from real estate is the rent generated by the property. It is crucial to get the projected rent price correct. There is no magical formula to determine how much you can charge for rent. The primary way to see how much rent you can get from a property is to look at comparable properties and see how much they are charging for rent. By looking at similar properties there will be a range of rents and the potential property’s projected rent must be somewhere in the middle. The projected rent should never be on the high end of the market. It is even better if the investment team has other similar properties in the area, they can compare rents with those properties.
Sure, the investment team might market the rent at the high end of the market but if rents dip or the renovation strategy doesn’t go as planned there is a built-in rent buffer.
Even the best properties have potential risks. It is imperative that the investment team identifies these risks and creates strategies to mitigate them or avoid them altogether. Suppose one of the business strategies is to implement a RUBS program to a property where no other properties in the area have RUBS programs the investment team needs to have a plan if the vacancy rises and they can’t fill units. Maybe the plan is to lower the rent to offset the costs to the tenant or maybe stop the RUBS program altogether. Either way, the mitigation strategy needs to be in the underwriting in case the business plan doesn’t go to plan.
Stress testing is a term used where the investment team manipulates the numbers to create worse-case scenarios where if “this” were to happen, the property would still be able to pay the mortgage. An example of a stress test adjusts the amount of vacancy a property can withstand. The investment team can increase the vacancy to a point where the property is breaking even. The investment team could present stress testing occupancy at 60%. This means the property can pay all expenses and the mortgage at 60% occupancy. There is no hard number that a property needs to be at for a vacancy stress test but the lower the vacancy the better. Most multifamily properties are at 90-95% occupancy so if the stress test comes back at 86% that is cutting it close.
The type of financing you plan on utilizing for the acquisition of the property plays a significant role in mitigating the risks of real estate investing. There are hard money loans, bridge debt, mezzanine debt, CMBS loans, adjustable rate, agency debt, etc. What we look for in “good” financing is a fixed rate with at least a 7-year term.
The fixed-rate debt avoids the interest rate going up if the market takes a turn for the worse. Of course, if interest rates go down you would be better off with an adjustable-rate mortgage but no one knows what interest rates are going to do and we do not feel comfortable adding speculation to our deals.
7-year terms give enough time for a property to weather an economic downturn whereas a 3 or 5-year term might be forced to sell the property in a bad time giving investors lowered returns. The worst time to sell a property is when you have to sell a property because the loan is coming due and the current market is worse than when you acquired the property. With a 7-year term, this allows the investment team to sell the property before the 7 years is up if it makes sense but also hold the property if it is a bad time to sell.
It is important to know what the estimated cap rate is at the exit. There is only one exit strategy when it comes to real estate investing and that is selling the property. Some people say refinancing is an exit strategy but it is not an exit, it is just a continuation. The value of the property is a multiple of the NOI, the multiple used is called the cap rate. The property value formula is NOI / cap rate. So, for example, a property has an NOI of $500,000 and a cap rate of 6%, $500,000 / .06 = property value of $8,333,333.
Without getting too deep into cap rates, a cap rate is a formula that determines how much money an investor could make on a property. Properties with a lower cap rate are less risky while properties with a higher cap rate are more risky.
Cap rates fluctuate based on market conditions and other exterior factors. Maybe a market is starting to be seen as riskier so the cap rates increase or maybe the interest rates increase so cap rates increase across the nation. If you buy a property at a 6% cap, what is the cap rate going to be in 5-7 years when the property is sold? If we use the property from above where at a 6% cap the property is worth $8,333,333, at a 6.5% cap rate it is worth $7,692,307 and at a 7% cap rate it is worth $7,142,857. Of course, cap rates can go the other way and you make more money but it is dangerous to assume that. If a higher cap rate isn’t planned for in the exit strategy the profit from the property can take a huge unexpected decrease