I feel fortunate to have access to many deals. However, I ultimately choose to join only select ones that meet my and my investors’ investment criteria and adhere to fundamental underwriting principles.
It is not easy (or comfortable) to say no. Nor is it easy to move slow and steady in a dynamic field like real estate. However, if anything, times like todays, are teaching us is that adhering to fundamentals is key.
In today’s quick snippet I summarize the top four underwriting mistakes I have observed lately.
For avoidance of doubt, I use the term mistakes when evaluating the underwrite relative to my risk tolerance and investment criteria. Just because I deem a deal aggressive or thin, does not necessarily mean other syndicators in the space would view it as such because their risk tolerance and investment thesis may by different.
So let’s dive in!
As noted in some of our prior articles and videos, the cap rate has a multiplier effect on the value of a real estate asset. Think of it as the inverse of the EBITDA multiple typically used to value businesses. As such, making the right exit cap rate assumptions could have a profound impact on the exit value of the property and therefore on the overall projected returns.
We are at the peak of interest rates today. However, I personally do not know where rates would be three, five, seven years from now. If I did, I would be in a different kind of business for sure. As such, I personally choose to take a more conservative approach and assume the market will get worse at the time of exit and like to project increasing cap rates at the time of exit. (For certain primary markets like Los Angeles or New York flat exit cap rates may be a reasonable assumption.)
If you are a syndicator who firmly believed rates will fall materially and will stay as such, you are likely going to assume cap rate compression at the time of exit. Many professionals in the space I speak to point to the Costar underwriting report cap rate projections, which currently reflect a projected decline in cap rate. However, this is only ONE data source and a only projection after all.
When looking at the long term history of interest rates, where we are at today is close to that historical average. Thus, I personally believe that even if rates fall, we would not be back to nearly 0% interest rates (unless a major global or macroeconomic event happen, which is always possible). For this reason, I like to project at least some cap rate expansion.
#2: Low or no working capital (aka rainy day fund) reserves.
The reality is that once an operator takes over a property a lot of unexpected surprises happen. It is not an IF but a matter of WHEN. It is absolutely impossible to forecast every obstacle or wrinkle that would emerge along the way. This is where adequate reserves come in.
For example, no one could have predicted the massive increase in insurance premiums over the past two years (which increased 2x and 3x in certain markets like CA, FL, TX). While operators running properties in those markets likely had some insurance increase forecasted, it was likely not 2x. This is where having an adequate rainy day fund helps.
Similarly, I’d like to see at least a 10% capex buffer because change orders and rehab surprises almost always happen.
#3: No stabilization period.
I am yet to see a property that goes from zero to hero on day one (except perhaps for turnkey residential properties). Almost always it does take time to transition the books and records, utilities and other contracts, and to get the tenants accustomed to the new policies and procedures in place (including paying rent on time). If the business plan includes unit rehab work (which a typical value add multifamily deal does), then there will likely be a period of vacancy to rehab and then to lease up the unit. For this reason, I get very nervous when I see projections that do not factor in this timeline (a 12-18 month period required to stabilize the asset).
#4: Unrealistic rent or expense assumptions.
Last but not least, having unrealistic rent or expense assumptions not in line with the market can also make or break a deal. Examples of such would include – not adjusting insurance and taxes, assuming a very low expense base, projecting consistently high rent growth outside of market norms, etc.
Needless to state, skipping on any of these points (e.g. lowering exit cap rates, assuming low or no reserves, not factoring in a stabilization period, or making aggressive rent/expense assumptions) inevitably impacts returns favorably. This is why it is important to look under the hood and peel the onion, so one can determine if they are being presented with a 17% IRR deal that is truly a 7% IRR deal in disguise.
I hope sharing the trends I have observed in deal flow lately added value to you and can empower you to make prudent investment decisions along your investment journey.
Should you have any questions or want to learn more about real estate investing or for an overview of our target markets, please reach out to info@dbacapitalgroup.com.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.