Underwriting a multi-family property transaction can be one of the most exciting aspects of the deal. It’s an opportunity to draw on your knowledge and experience to dig deep into the numbers and thoroughly understand the return and risk profile of a potential investment. However, as we at Lumina have seen time and time again, investors regularly make mistakes when underwriting, often leading to disappointing returns.
To help you avoid mistakes in your multi-family property underwriting, in this article we’ve outlined the six most common mistakes we see investors make during the underwriting process.
1. Overestimating Market Rent
When underwriting, it can be easy to overestimate the property’s potential. While it’s good to be optimistic in many aspects of life, when it comes to estimating market rent on a multi-family property investment it pays to be as hard-nosed and realistic as possible.
For starters, you’ll want to take the selling broker’s opinion of market rent with a grain of salt. The selling broker benefits from selling the property at the highest price possible, so it’s in their interest to be optimistic about rents and their expected future growth rates. If you have any doubts about the estimates they have provided, don’t be afraid to ignore them altogether.
The best way to gather the best market rent estimates is by doing your own research. Look at properties in the area to see what they are charging, then compare them against the property you are underwriting to determine whether the property. If a nearby property offers bigger units, newer amenities or leasing concessions, be sure to account for those differences and factor them into your market rent estimate to make sure you are comparing apples to apples. Websites such as Zillow or Apartments.com are often very transparent and can be hugely valuable.
At the end of the day, even if you think the subject property can achieve above-market rent, you’ll be better off if you err on the side of caution and slightly underestimate the rent potential in your underwriting. Under-promising and over-delivering is better than using a rent estimate that the property could only meet in a best-case scenario.
2. Underestimating Expenses
Just as it’s easy to overestimate market rent, it’s also easy to underestimate expenses. You may think you’ll be able to cut expenses from day one, but it’s rarely that straightforward.
A common strategy multi-family investors utilize to reduce a building’s expenses is to begin billing utilities back to the residents. In theory this seems like an easy way to improve your underwriting model since you’ll no longer be responsible for paying water, electricity and gas bills, but it’s not necessarily that simple. In theory, a unit for which the tenant pays directly for utilities should rent for less than an equivalent unit in which the tenant does not pay directly for utilities.
Another expense-related issue you might run across involves property management. If you are purchasing an internally managed property and you plan to hire a different management company when the transaction is complete, you’ve just created a situation that leaves no incentive for the current management team to keep expenses low.
Lastly, don’t forget to account for future changes in taxes and insurance when making your expense estimates. There’s a good chance the property will increase in value while you hold onto it for the next few years, so make sure your estimates account for future increases in taxes and insurance premiums. This is especially true if you plan to do renovations on the property that might significantly increase its value, in which case the taxes and insurance will likely increase as well.
Being optimistic about future expenses might make your spreadsheet look better, but don’t make the mistake of underestimating expenses during the underwriting process. If you do, you may find that even your best-case rental rate scenario isn’t sufficient to cover the expenses you didn’t account for.
3. Inadequately Budgeting for Capital Expenses
Capital expenses are related to any upgrades or renovations you plan to make to the property. Although you typically have some level of control over these expenses, you still need to be conservative in your estimates during the underwriting process.
If there was one word to describe renovation projects, it would be “delays”. Whether it be a slow supply chain, an issue with a contractor or the work simply taking longer than anticipated, it’s a common occurrence for renovations to miss their deadlines. When this happens budgets can get tight, and there’s not much you can do about it.
Another problem you might run across is an abnormal increase in the price of materials. The prices of lumber, steel, glass and concrete all fluctuate in response to supply and demand, and the price you thought you were going to pay could be significantly higher once you get to the closing table.
To protect yourself against these problems, it’s important to give yourself an adequate budget when underwriting the project. You should plan to have roughly two to three times the cash you anticipate needing for any renovations to ensure you don’t find yourself coming up short.
4. Focusing Too Much on Cap Rate
If you don’t know, capitalization rate, also known as the cap rate, is a way to calculate the return on a real estate investment based on the property’s income. Calculated by taking the property’s annual net operating income and dividing by the purchase price, the cap rate gives investors a quick, helpful ratio for evaluating the profitability of their investment.
Many investors place too much importance on the cap rate, which can hinder the underwriting process and result in poor investment decisions. There is a lot the cap rate doesn’t tell us. For example, expected growth in net operating income, the cost of capital expenditures, and the overall risk of the investment, are all factors the cap rate doesn’t capture.
To avoid the mistake of putting too much focus on the cap rate, take a holistic view of the investment while underwriting, considering metrics like the internal rate of return (IRR), cash-on-cash return, equity multiple, and debt service coverage ratio (DSCR). If any of these indicators don’t meet your investment criteria, there’s nothing wrong with taking a step back and re-evaluating the investment. Calculating your investment’s cap rate during the underwriting process is an important step, but should not be the sole focus.
5. Insufficiently Researching the Market
Your underwriting will only be as good as the assumptions and numbers that go into your analysis. If you put good information in, there’s a better chance you’ll get good information out. This is why having thorough and reliable market research is so important.
Unfortunately, many investors don’t make the effort to sufficiently research a market before investing.
Is the market growing or shrinking? Does this area of town have a higher crime rate than average? Who is my likely tenant in this area? Is this an affluent or low-income neighborhood? How have rents trended over the last five years? Where are they forecasted to go over the next five years?
The answers to these questions and others like them are vital to making an educated investment decision, yet so many investors rely on little to no market research and are led to make poor assumptions during underwriting and, in turn, poor investments.
There are a number of valuable resources at your disposal to aid in market research. Most of the major brokerages produce periodic research by market, such as Colliers and Marcus & Millichap.
Of course, you can never know every piece of information relevant to your investment decision, but having an in-depth understanding of the market your property is located in will make your underwriting that much better.
6. Failing to Adequately Assess Risks
As with any investment, investing in a multi-family property does have some risk. The market could turn and limit your ability to sell the property, rent growth could slow and limit your upside or vacancy could be higher than expected. If you fail to adequately assess risks like these and they ever come to fruition, it can be disastrous to your bottom line.
We believe sensitivity analyses play a huge role when assessing such risks. From an absolute best-case scenario to a complete disaster, a sensitivity analysis can account for almost every situation and show you where the investment’s vulnerabilities might be and which risk factors you should pay particular attention to.
Conclusion
We hope this article gave you a good understanding of the most common mistakes made when underwriting a multi-family investment property and how to avoid them. Underwriting can be labor-intensive and time-consuming, but it’s an extremely important part of the investment process.
If you’d like to learn more about investing in multi-family real estate or have additional questions that weren’t answered in this article, reach out to us at info@luminareia.com.