Real Estate Underwriting & The Myth of “Conservative” Labeling

Real Estate Underwriting & The Myth of “Conservative” Labeling

 

Almost four years ago, I had an in-person appointment to discuss a prospective real estate syndication with a well-known operator that was local to me. At that time, I had been investing in small residential rentals for six years, but I was brand new to syndications.

I was both nervous and excited. The era of podcasts had made pseudo-celebrities out of operators that frequented as guests, and this particular operator was one of those celebrities that had a strong investor following, so just to get an appointment was a big deal for me. I met him at his office, and we had a great conversation that left me impressed. To be fair, it’s easy to become impressed when you first discover syndications because the potential returns can be so lucrative. However, I soon discovered that nearly all operators try to make investors feel safer by alleging that their deal is “conservative.

Since that meeting, which led to my first syndication investment, every deal that I’ve looked at (and there’s been hundreds) has also included the word conservative.

Could it be that I’m the most fortunate investor on the planet coming across the safest deals, or has the word conservative taken on a completely different meeting in the syndication world?

Let’s take a closer look.

What Does Conservative Underwriting Actually Mean?

Syndications have a wide range of potential annualized returns, with a typical apartment building investment falling in the range of 12%–20%. Determining how much risk you’ll need to assume in order to realize those returns requires a due diligence process called underwriting—which is essentially a series of financial analyses that project the performance of a deal.

During the underwriting process, you’ll need to examine the operator’s business plan, which should outline multiple “levers” they can pull in order to try to increase the property’s income, decrease its expenses, or a combination of the two. Some of the most common levers are renovating apartments, adding amenities, and installing energy-efficient features throughout an apartment complex. If the deal comes in closer to the lower range while using less levers that are at the disposal of the operator, then the deal might fairly be labeled conservative. I say might because the changes instituted need to be absorbed by the market in which the deal is located—meaning that just because the changes worked in other locations, they might not work in this exact location. For example, a dog park has historically increased rent by $100 in every city in which the operator has done business, but on their latest project, the dog park is not well received and can’t support the rent increase. So while the idea is sound and has a long track record of working elsewhere, this exact location didn’t absorb the dog park as imagined.

You should also be able to determine whether the deal will require every aspect of the business plan to be executed perfectly, or if just hitting on a few aspects would meet the projected returns. The more levers left to pull after meeting the projections, the higher the potential for outsized returns. The key to gaining clarity is having the operator clearly articulate their plan, including the levers and an explanation about the assumptions being used.

STEP 1: OBTAIN THE APPROPRIATE UNDERWRITING SOFTWARE

While underwriting can be outsourced, it’s very expensive to do so. Therefore, as a passive investor evaluating prospective deals, you’ll need to hone some basic underwriting skills—including a working knowledge of Excel and formulas—and obtain a software program that walks you through this important process. There are a few popular and affordable solutions available that are essentially Excel spreadsheets with multiple interconnected tabs that also provide guides and videos that simplify the process. After you enter variables for a prospective deal, such as sales price, rent, etc., the software propagates data that allows you to track metrics, valuate assets, make comparisons, and forecast performance.

If you decide to join a syndication coaching program or mastermind, your membership typically includes underwriting software, but your network is also a great source for obtaining recommendations. Just make sure you ask what your contacts like and do not like about the software they have used.

A lot of new investors stray initially by trying to create their own underwriting spreadsheets, but this is not recommended, regardless of how good you may be at creating and interpreting Excel sheets.

STEP 2: OBTAIN THE CURRENT VARIABLES FOR THE PROPERTY

There is a document that is usually provided to an operator from a seller called the T-12, which is a profit and loss statement covering the property’s performance over the previous 12 months. Essentially, it provides a snapshot of how the asset performed right before the sale. As a prospective investor, you’ll want to examine this document for trends and the ability to benchmark the deal, including factors like occupancy and rent prices throughout the year, as well as total operating expenses compared to total operating income. Keep in mind that newer properties may have lower operating expenses, while older properties (where utilities are included) will have higher operating expenses—but in either case, 50% is usually the gold standard for the operating expense ratio (OER).

PRO TIP:

Be wary of a sudden spike in occupancy right before the sale, as this can represent “packing the occupancy,” the practice of a seller lowering their standards in order to increase a property’s occupancy just before a sale to make it look more attractive to investors. On the other side of the acquisition, the occupancy tends to drop quickly.

By just taking these two steps, you will already have gotten farther than most investors ever do.

STEP 3: OBTAIN THE OPERATOR’S ASSUMPTIONS ON KEY PROFIT AND LOSS VARIABLES

In looking at the operator’s business plan and ask the following questions:

  • What is the projected occupancy level? Is it significantly higher than what the previous owner showed in their T12—if so, why? It’s okay to have a plan to get to higher occupancy over the long term, but planning for it right away should be a red flag.

 

  • How long will it take for any potential rent increases to be implemented, and what are the projected rent increases year over year? One way operators use to try to make the numbers look appealing is projecting the income to grow significantly higher into the life of the deal.

In reality, if it’s a big value add project and a huge market rent discrepancy between competitors, it’s normal to see a big rent spike the first few years, but then revert back to a more normal 2% annual rent increase and a 2% annual expense increase.

  • Does the business plan show a significantly lower OER than the previous owner? If so, why? Operating expenses take a while to come down, even with the best operators. They may come down faster if the plan is structured correctly, but if none of the levers deal with lowering expenses, then something is wrong.

Always remember that if the underwriting process uncovers too many red flags in a deal, you can simply walk away. If it’s only one or two issues, reach out to the operator and frankly ask them what’s going on. I’ve had many deals that stop at this point because the operator just stopped all communication dead in its tracks.

While disconcerting, that is always a much better outcome than committing to a deal with a dishonest operator.

What Is the Time Commitment?

Underwriting has an aura of difficulty associated with it that acts as a natural impediment for those just getting started, but in reality, it’s not as difficult as it sounds, and it often takes less than a year to become proficient at the skill. Keep in mind that there are different levels of underwriting, and there are people who dedicate their entire careers to honing this craft. But for a passive investor, having a basic understanding of underwriting can help you sniff out a bad deal—in fact, it sometimes it takes as little as 10 minutes to decide if a deal really is conservative or just another myth.

 

 

If you liked this article and wish to continue on your path in learning about alternative investments, please make sure to check out my other educational articles as well as my bookThe Alternative Investment Almanac: Expert Insights on Building Personal Wealth in Non-Traditional Ways

Disclaimer: The information presented in this article is for informational purposes only and does not constitute professional financial or investment advice. The author does not make any guarantees or promises as to the results that may be obtained from it. You should never make any investment decision without first consulting with your own financial advisor and conducting your own research and due diligence. Even though, the author has made reasonable efforts to ensure that the contents of this article were correct at press time. The author disclaims all liability in the event that any information, commentary, analysis, opinions, advice and/or recommendations contained in this article results in any investment or other losses. Your use of the information in this article is at your own risk.

 

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