Why Use Conservative Underwriting?
When underwriting a multifamily real estate asset, approaching projections of future performance with a conservative perspective is crucial. It is possible to make even the worst and riskiest deals look like home runs on paper without this approach. It is only when these principles are understood and implemented that GP teams can identify those assets which provide strong returns to investors and weed out underperforming assets-protecting LP investments and boosting investor sentiment. It is arguably more important for LPs to understand these concepts themselves so they can have the understanding to point out when an offering may be too good to be true and based on too aggressive underwriting. One of the best ways to vet a GP is by taking a deep dive into their underwriting. The offering could seem like a homerun when a 20%+ IRR is in bold on the front page of the offering but when 4% income growth from day 1, flat or even contracting residual cap rates, and a 24-month full value-add/exit is behind the calculations; the deal could easily turn into a single-digit IRR project when more realistic numbers are factored in.
There are many aspects of underwriting that can be investigated in this article however I will only be highlighting four of the most essential and sensitive factors: income growth, residual cap rate expansion, hold time, and value-add realization.
I. Income Growth
Income growth is exactly what it sounds like. When dragging the pro forma performance of the property across 10 years in the future, there is a factor of growth expected to be applied to rents. This is to account for the long-term appreciation of rents due to inflation as well as supply and demand. This does not come from value-add initiatives, simply natural rent growth. Common numbers for this factor are somewhere between 2 and 3 percent. This factor is a very sensitive input, meaning even a small delta has a large impact on the project-level IRR calculation. In an effort to be conservative, a good practice is to suspend rent growth during the value-add time frame of the project, if one is present. Furthermore, in market conditions such as the ones we are seeing at the time of writing (nearing the end of 2022), with recessionary macroeconomic policies in effect (tightening of the money supply with rising interest rates), it does not make much sense to underwrite at or above-average rent growth in the near future.
To demonstrate how sensitive this input can be, I will use my underwriting from a 24-unit asset near the Charlotte, NC market. With 3.0% income growth from Year 1 – Year 5, the projected IRR is 20.42%. When we take income growth down to 0% for the first 24 months to account for both value-add initiatives as well as uncertainty in the macroeconomic climate, the projected IRR drops to 15.62%.
II. Residual Cap Rate Expansion
One of the most arbitrary but sensitive (dangerous combination) factors in underwriting is the residual cap rate. This is the projected prevailing cap rate at the time of project exit. This input is so sensitive because it directly affects the residual property valuation, which directly affects the project-level IRR. If it is such an arbitrary number, how do operators project it? Common practice includes taking current prevailing market cap rates for a stabilized version of the asset and adding an annual expansion factor. This factor is directly added to the current cap rate each year in future valuation calculations, increasing the residual cap rate with each year that passes in the project hold time. It is common to see cap rate expansion factors of 10-15 basis points.
Failure to include this factor in underwriting is a mark of inexperienced underwriting that can be very misleading at project-level returns. Using the example underwriting of the same asset as in Part I, I will show how leaving this factor out can inaccurately inflate project performance. With a residual cap rate expansion of 10 basis points and a project hold time of 5 years, the projected IRR is at 15.62%. Overlooking this factor and underwriting at flat cap rate expansion produces a projected IRR of 19.53%, almost 400 basis points higher.
III. Hold Time
As an LP and potential passive investor, it is important to find deals that align with your long-term goals. If you are wanting stable and strong cash flows from day 1 and a long-term hold, a heavy value-add deal with a 3-year hold time may not be the best place for you to put your money. For projects that are heavier value-add deals that have a shorter projected hold time, it is important that the operator not be too optimistic and aggressive when projecting the project’s hold time. This is because IRR is actually very sensitive to project hold time. Even if a project’s value-add only includes eliminating loss-to-lease, underwriting at a 12-month hold may be entirely unrealistic given the number of units and even the legal environment of the market. Not only is it unrealistic, but it is also inorganically inflating the projected IRR. This is because IRR is a return metric that accounts for the time value of money. Therefore, cashflows that are distributed in Year 1 are worth more than equal cash flows distributed in Year 2, since Year 2 cashflows are discounted. By projecting a liquidity event too soon, you are inflating its weight on the IRR.
In the same example underwriting as above, a hold time of 2 years projects an IRR of 25.45%, while a more realistic (depending on the project) and conservative hold time of 3 years projects an IRR of 19.81%.
Note: Underwriting at a project hold time of fewer than 5 years can be tricky in and of itself as rate risk and cap rate volatility increase as hold times become shorter.
IV. Value-Add Realization
With projects that have a value-add component, the length of time until the full value-add is realized and reflected in NOI can be a very sensitive and often misrepresented factor. Although this seems obvious, often fully optimized NOI can show up in underwriting at the start of Year 2 or even day 1 (huge mistake), even on 100 unit+ deals. This will throw project valuations way off track and inaccurately inflate valuations, especially when you think about the income growth mentioned in Part I being compounded and applied to these inflated NOI numbers. Nevertheless, this is a difficult factor to include in underwriting. How do we include value-add realization to our NOI at a reasonable rate? One way, and the way I have elected to use, includes taking T12 performance and then separately noting pro forma performance (performance at 100% value add completion). Then, come up with the length of time it will take to get NOI up to pro forma numbers – based on renovation scope, the number of units, etc. Finally, use a straight-line method to gradually increase NOI to pro forma NOI over the number of years it will take to get there.
For example, T12 NOI is $120,000 and pro forma NOI should be $150,000 (the premium is $30,000) and we estimate the value-add to take 24 months. Our Year 1 NOI will be $135,000 and Year 2 NOI will be the full $150,000.
Be wary of projects with a shockingly short amount of time allotted for value-add be sure to poke around as the LP to be sure the GP is fully aware of the implications of their value-add plans and be sure the projected returns are being reasonably calculated.
Wrapping Up
As with all things, there is a balance here. While being too aggressive when underwriting can lead to pursuing an underperforming deal for investors, underwriting too conservatively can lead to you never being able to pull the trigger. The idea here is to be able to defend all factors present in your underwriting.
These four factors are very sensitive and should be treated with caution by operators as well as carefully analyzed by potential investors to ensure reasonable return projections.
Thank you for taking the time to read this and if you found it valuable please consider sharing it with friends!
Dream bigger,
Jaden George
HorizonTen Properties
