Underwriting During Recessionary Times

With a possible recession looming, inflation, and interest rate hikes, there may soon be increased buying opportunities. Property prices may level, or at the least, there may be more supply on the market. Though investors should always underwrite conservatively, doing so during economic uncertainty takes on even more importance. There are benefits to buying during economic uncertainty, so be ready to pounce on those opportunities. Here are some ways to adjust your underwriting as a result of the foregoing:

1. Adjust Exit Cap Rates

If your underwriting calls for a refinance, sale, or other capital event, adjust your exit cap rate. As interest rates rise, you can expect cap rates to level. Cap rate movement will, of course, be market and asset class dependent, but as a baseline, consider adjusting your exit cap rate by a quarter point per year you are holding the property. This will help cover the investment in the event that a recession causes valuation decreases or interest rates continue to rise.

1. Adjust Interest Rate Expectations

During a time where additional interest rate increases are likely, consider underwriting for a quarter point interest rate hike on your going-in rate (at least until your rate is locked). Also, importantly, underwrite for continued interest rate hikes if your business plan calls for a refinance after a couple years. Planning to refinance tomorrow at today’s interest rates could falsely skew a deal.

1. Decrease Income Growth Projections

The market saw record rent growth in the past two years due, in part, to rampant inflation and limited supply. Whereas the “standard” income growth underwriting projection was 3%, it was not uncommon to see double-digit rent growth in some markets. While some undersupplied markets may continue to see fantastic rent growth, it is likely that the market will come back down to where it has been for decades. As such, it may not be prudent - depending on your market and asset class - to continue underwriting at 5%, 7%, and 10% rent growth.

1. Decrease Occupancy Projections

Like income growth, occupancy has been at record highs in the past couple years. In self-storage, for example, historical occupancy sat around 86% pre-2020, but since April 2020, has risen to 95%. The COVID-19 Pandemic resulted in an unprecedented market shift, whereby people were moving more than ever before, increasing self-storage demand. While the COVID-19 Pandemic certainly changed consumer behavior, following the decades of data suggesting that a 95% occupancy may not be sustainable, is certainly the more conservative underwriting approach.

While a market downturn presents an incredible buying opportunity, it can be equally dangerous for investors that underwrite today’s deals using yesterday’s numbers. What are you doing to apply proper market data and underwrite conservatively as the market shifts?