Thoughts on Underwriting Fundamentals

Underwriting is one of the most important aspects of multifamily investing. Proper, conservative underwriting can save an investor from jeopardizing their retirement or career.

Warren Buffet's "margin for error" - Buffet often explains the key to making a smart investment is to ensure the investment has a sufficient margin for error. This means if some of the assumptions of the investment turn out to be too ambitious, the investment still has the ability to perform and most importantly, avoid a permanent loss of capital.

Conservative Underwriting Means...

• Making reasonable market cap rate assumptions as well as forecasting terminal cap rates based on market volatility and investment timeline. A primitive method of making terminal cap rate assumptions is by adding 50 to 100 basis points to the going-in cap rate. This is especially unreliable when purchasing value-add or distressed property which lacks sufficient going-in cash flows. Lastly, it may be tempting to forecast where market cap rates and interest rates will be in five to ten years, but macro-forecasting should be left out of these models as much as possible.
• Constraining organic rent growth assumptions. Due to the sensitivity of this input, it is unwise to place disproportionate reliance on organic rent growth in order to meet minimum return requirements. One reason why this input is so sensitive to the final results of the underwriting is because an annual rent escalator is a compounding input and the terminal NOI, which has been compounded over five or ten years, is used to calculate exit pricing.
• Using the exit year’s T12 NOI or T3 NOI to calculate terminal valuations. It is not uncommon to see five-year exit prices calculated by using year six NOI (thus continuing the compounding of organic rent growth and overstating the future underwritten NOI).
• Understanding the time required to reposition the asset in order to achieve pro forma revenues. While rent comparables are a strong way to substantiate pro forma revenues, rents and occupancy can’t change overnight. Based on the lease terms, scope of work, vacancy delta, and the total number of units all factor into the repositioning timeline.
• Paying close attention to debt service coverage ratios, especially during the stabilization period for a value-add deal. It is paramount to track free cash flow at the monthly level rather than annually to determine interest reserve requirements. Furthermore, DSCR levels, interest reserve, and free cash flow are closely tied to pro forma revenue assumptions and the time it takes to reposition the asset to achieve these premiums. This means aggressive renovation timeline assumptions could lead to underestimating the amount of interest reserves necessary as well as the amount of free cash flow available during the stabilization period without really realizing it.
• Placing importance in unlevered IRR figures. Sometimes it is easy to get lost in making financing assumptions which is an easy way to make a deal look much better (don’t forget leverage cuts both ways; pay attention to DSCR). Assessing project level returns based on unlevered IRR is a good way to remove the noise of debt assumptions and compare investments in a more “apples to apples” manner.
• Including replacement reserves “above the line” as an operating expense. We assume that our replacement reserves are spent completely each year.
• Understanding property tax assessments and the rate of increases as well as the implications of the transaction on the future assessed value.
• Being cognizant of expenses on a per unit basis as well as total operating expenses as a percentage of effective gross income.
• Considering all of the transaction costs associated with the purchase and future sale such as legal fees, financing fees, due diligence costs, commissions, title fees, prepaid taxes and insurance, and soft costs. Additionally, an operating budget needs to be raised before closing in order to adequately fund operations at management takeover.
• Avoiding modeling investment hold periods shorter than three years. For normalization purposes, we underwrite almost everything to a five-year hold period. Shorter hold periods typically increase IRRs, especially for value-add deals. However, the shorter the hold period the more returns are derived from capital gains rather than cash flow. For conservative investing and non-opportunistic investments, cash flows should make up a meaningful portion of the projected return because this mitigates risk. Cash flow is easier to underwrite and achieve than appreciation, which is largely dictated by the short-term swings of the market. If an investment must be underwritten with a shorter hold period, then careful attention should be paid to stabilized, operating cap rates (including capital expenditures in the basis), stabilized cash on cash, and to the ability to refinance.
• Demanding adequate risk premiums. A value-add deal with core level returns is not a good investment. With each incremental increase in risk (yes, risk is impossible to quantify but still should be assessed), the investment should project a commensurate increase in return. Requiring adequate risk premiums is important because it not only helps to achieve strong risk-adjusted performance but also provides a margin of safety against the most potent risk of all: permanent loss of capital.