Updated: Aug 31
Nearly every underwriter in the multifamily industry claims to have a conservative approach to the numbers. However, what exactly does conservative underwriting mean? You might assume that this involves mitigating risk as much as possible by assuming worst case scenarios, but conservative underwriting can look differently for every underwriter.
While most passive investors won’t take the time to learn the ins and outs of underwriting, it is important to have a foundational understanding of the assumptions an underwriter is making in their business plan. This allows you as the passive investor to know what risks the operator is taking, and to determine if you are comfortable with those risks.
Why is conservative underwriting important
If you want to do your own due diligence on an operator and their assumptions for a specific deal, it’s essential that you understand the assumptions and projections they are making in their underwriting. One of the best ways to mitigate risk is to understand what risks you are taking. Conservative underwriting acts as a safeguard which will allow you to build and grow your real estate portfolio.
What exactly is conservative underwriting?
Underwriting is a process of financial analysis used to project the future performance of a multifamily property. Underwriting involves assessing the business plan of the operator.
Ideally, an operator will include multiple “levers” they have at their disposal they can pull in order to increase revenue, decrease expenses, or do both. Levers can include improving the condition of the property, adding community amenities, or implementing a Ratio Utility Billing System (which splits a utility bill among tenants based on specific criteria).
Conservative underwriting isn’t an exact science. Essentially, how conservative an underwriter is depends on how aggressive the assumptions they are making are. If they assume that their projected annualized return is on the higher end, and they plan to pull a majority of their “levers,” then they might not be that conservative.
It is important to note that the market plays a major role in determining how conservative an operator’s assumptions are. Levers that work in one market may not work in another. For example, adding certain interior upgrades to an apartment complex may allow the operator to increase rents at one property, but in another market, residents may not be willing to pay that higher rate.
How conservative an operator’s assumptions are can be reflected in how many levers need to be pulled in order to meet their projected returns. If they only need to pull a few levers, while having multiple other levers left in their back pocket, in order to meet their projected return, then they might be fairly conservative.
This is why it’s essential to have an operator explain their assumptions, and the levers they have to pull in order to meet (and hopefully surpass) their projected returns. Investors assess a potential opportunity to determine if it can generate the returns that support their investment goals. The details of underwriting a deal will vary depending on the property type you are dealing with. Developing a mobile home park is much different from renovating an existing Class B apartment complex.
When reviewing an operator’s rent assumptions, make sure to gather information relating to the units at the property. This includes current rent, square footage, vacancy trends, etc.. With this information, the operator projects what value-add premium these rents can achieve. In other words, they determine how much they can charge in rent once they implement certain upgrades to a given unit.
If an operator plans to implement renovations overtime, then their projected rents should reflect that. Rents should increase slowly over time, as the business plan is implemented. Their pro forma should show the gradual increase in rent and the stabilized results once the renovations are completed. Typically, operators will assume that the annual rent increase will be between 1-5% for a given property during its hold period. According to a September 2021 Yardi Matrix Report, multifamily real estate experienced an average rent increase of 11.4% year over year. An iProperty Management source reported that average rental rates have increased at a historical rate of 8.86% per year since 1980.
To conservatively underwrite, one might assume that market rent can’t be achieved until 2-3 years into the business plan. A conservative approach would involve no rent increases within the first 12 months.
Let’s first break down the different kinds of vacancies. Physical vacancy involves a unit without a tenant. Economic vacancy involves a tenant who is living in a unit but not paying rent and is perhaps behind on payments (known as bad debt). Concessions, which are promotions to encourage tenants to sign a lease, can also account for economic vacancy. An example of a concession is a free month of rent.
To underwrite vacancy conservatively, one might assume a higher vacancy than they currently have. So, if the financials show a vacancy of 3-5%, an operator might assume vacancy is between 10-12%.
Historical operating expenses play a key role in determining what future operating expenses will be. For example, understanding what the previous operator spent on electricity will be a strong indicator of what the new operator can expect to spend when they initially take over. Some operating expenses include:
Property Management fees
The majority of these expenses will not change during the renovation period or the stabilization period. With both a firm understanding of the revenue and expenses at a given property, the operator can determine what the Net Operating Income of the property is, and project what it will be during their hold period. Keep in mind that renovation costs are not included in the operating pro forma.
Another common mistake operators make involves property taxes. Many operators fail to project higher property taxes because their purchase price is greater than the property’s current appraised tax value. As a general rule of thumb, when it comes to expenses, a conservative ratio of operating expenses is between 50% and 60%.
During the hold period of a multifamily asset, unexpected expenses may come up. This is when replacement reserves come in handy. If you end up needing to repave the parking lot, or the plumbing system, having a reserve of capital is essential.
A general rule of thumb is to have $250-$300 per unit per year in reserves. This should also be factored in as an operating expense, which means it should be factored in when calculating the NOI of the property. This ensures that the projected returns are still realistic even in the event of a major unexpected expense.
Cap Rate Assumptions
Cap rates only matter if you are buying or selling a property. So, while a cap rate may not be a critical factor during the hold period of your property, the cap rate at the time when you’re looking to sell matters. A higher cap rate lowers the value of a property, and a lower cap rate increases the value. To be conservative in our underwriting, we increase 10 basis points minimum per year of hold.
As the seller of a property, it is advantageous if the cap rate is lower than it was when you bought the property. But, to be conservative, assuming the cap rate will be higher can strengthen your conservative underwriting assumptions.
Determining the Property Value
The formula to determine the value of a given property is simple.
Property Value = Net Operating Income / Capitalization Rate
You can find the property’s net operating income in the stabilized pro forma. The cap rate varies per market. As defined by Investopedia, a property’s cap rate is the rate of return on a real estate investment property based on the income that the property is expected to generate.
What to Do as an Investor
Get an underwriting model
To effectively evaluate prospective deals, you need to be able to develop basic underwriting skills. Underwriting today involves the use of Excel, formulas, and a software program that details the underwriting process.You can purchase a proprietary underwriting model, which usually comprises multiple Excel slides, and a tutorial manual or course that explains how to use it.
We use the Think Multifamily proprietary model, but you can find any model to your liking with a simple Google search. Some are more comprehensive than others, but it shouldn’t be difficult to find one that allows you to thoroughly vet an opportunity.
These models allow you to enter variables such as sale price, rent, and unit types. The model allows you to compare the property to others, make predictions, and determine the value of the asset.
Obtain the Underwriting Materials
To underwrite a property, you’ll need to have access to the deal’s T12. A T12 is simply a profit and loss statement for the property over the past 12 months. It allows you to assess how the property has performed leading up to the sale. You can use a T12 to look for trends, and evaluate metrics such as occupancy, rent increases, operating costs, etc..
Practice Makes Perfect
Understanding how to underwrite can take time, so be patient. The main goal is to have a foundational understanding of underwriting this type of property so you know what to look for when you evaluate passive investing opportunities.
Receive the Operator’s Key Assumptions
When you are reviewing an investment opportunity, ask the following questions:
What is the operator projecting the occupancy level will be? How does it compare to the previous owner’s occupancy level as seen in the T12? If it’s higher, how is the operator justifying their assumptions? Is it immediately higher, or more long term?
If it is immediately higher, this is a red flag, as it is an aggressive assumption (unless the operator has evidence to back up their assumption).
How long does the operator plan to take to implement any rent increases? Many operators will be overly optimistic about the rental revenue the property can generate during the hold period, so pay attention to how realistic the operator’s rent increase assumptions are.
How do the operator’s operating expenses compare to the previous owner? It can take time for operating expenses to decrease, so a drastic decline in operating expenses might be aggressive.
Operators base their projected sales price or refinance value on their projected property value. To calculate this projected property value, they divide their projected Net Operating Income by the cap rate.
Ask the operator how they determined the projected NOI, and what makes them confidence about their ability to refinance or sell.
Conservative underwriting involves underwriting assumptions that are reinforced by historical data, and projected returns that don’t depend too heavily on variable factors such as future rent growth. To protect your wealth as a passive investor, learning what questions to ask and what red flags to look out for in an operator’s underwriting can arm you with the tools you need to build wealth in real estate at scale. As Warren Buffet said, the number one rule of investing is to not lose money. And a great way to do that is to be aware of the risks involved with a given investment. While risk is nearly impossible to quantify, it is possible and critical to know what risks you are taking as a passive investor.