In commercial real estate (CRE) investing, underwriting serves as the foundation of all investment decisions.
This essential process involves the assessment of various financial, market, and property-specific variables to predict an asset's future performance.
When done correctly, underwriting provides investors with a clear road map that outlines potential risks, cash flow projections, and rates of return.
In a field laden with complexities, avoiding underwriting pitfalls is crucial for success.
While some of these errors might have passed unnoticed due to favorable economic conditions and a consistently growing real estate market, the margin for error is increasingly thinning out.
As an investor, it’s important for you to take note of these typical missteps now more than ever. Let's dive into -
When investing in multifamily real-estate, many CRE investors use the Value-Add Model to recalculate the exit capitalization rate (or exit cap rate).
The exit cap rate helps to estimate the potential profitability of the investment. But there's a catch: often, that recalculated rate turns out to be higher than expected.
Even a slight increase of one percentage point can turn an investment from ‘profitable’ to ‘not worth the risk.’ This situation reveals a strong dependence on what is known as ‘residual sales proceeds’ to make the investment work.
In other words, the entire profitability of the deal hinges on what you can sell the property for at the end of the investment period.
The problem is that the assumptions that go into calculating the exit cap rate can be easily changed, affecting the whole financial outlook of the project.
In more forgiving economic times, some investors got away with making this error because property values were rising fast and there was plenty of affordable financing available. However, relying on favorable market conditions is not a sustainable strategy.
To create a more balanced and less risky investment, it's a good idea to incorporate an analysis of different revenue sources in the financial model. That way, your profitability isn't solely based on the property's future sale price.
A well-rounded investment should generate returns from several sources, like the initial capital returned, ongoing cash flow, growth in that cash flow, and reductions in loan balances.
Taking the operating expenses provided by the previous property owners at face value can lead to unexpectedly risky outcomes.
This is especially true when it comes to costs like insurance and payroll.
Why? Because insurance costs have been on the rise, particularly due to substantial inflation in recent years.
The market has also seen some insurance providers pull out of areas prone to natural disasters, which further escalates the quotes.
To protect against unforeseen expenses, investors are advised to get their own insurance quotes before they finalize the property purchase.
Be sure to meticulously scrutinize the insurance expense for the first year.
Simply relying on the prior owner's data could lead to flawed assumptions, as those figures might not reflect the current market conditions.
Similarly, payroll expenses have surged in recent times.
High-quality employees in roles such as leasing, management, and maintenance are becoming more expensive and harder to hire.
Costs can fluctuate greatly depending on the size of the property and the efficiency of its operations.
To navigate this variable landscape, consult with an experienced third-party property manager for insights. They can provide a more accurate estimate of what these ongoing operational costs are likely to be.
Refinancing can have a significant impact on an investment's rate of return.
But caution is advised when building assumptions around refinancing, especially in the context of rising interest rates and a general pullback from lenders who are becoming risk-averse.
It's always wise to only factor in refinancing when it's a central component of the business plan, like n cases of multifamily development or significant property renovation projects.
Multifamily investors should remain skeptical if they come across investment packages that project an opportunity to refinance and return all invested capital within the first few years for stabilized projects.
The reality is that refinancing is highly sensitive to broader economic conditions.
Given the economic uncertainty and fluctuating interest rates, being overly optimistic about refinancing proceeds can set you up for disappointment.
This cautionary approach has become even more relevant in light of current economic conditions.
Many investors simply raise the property tax by a fixed percentage based on the previous year's amount.
This is not always the most accurate way to project this significant cost.
For a more nuanced estimate, it's better to consider two main factors: the sale price and any possible reassessment, as well as a comparison with similar properties in the area.
After all, property taxes can be a substantial portion of operating expenses, demanding a thorough and thoughtful approach.
Not paying enough attention to accurately projecting property taxes can have severe financial repercussions.
For example, if property taxes are expected to surge substantially in the upcoming year due to a change in assessments or other factors, overlooking this in your financial modeling could immediately disqualify an otherwise viable property from your investment portfolio.
An accurate projection is not just a nice-to-have but a necessity in maintaining financial viability.
Investors who target Class C or Class D properties may find that renovations don't always yield the expected return on investment.
Generally class B and C properties are riskier.
Over spending on high-end finishes and luxurious upgrades rarely results in a corresponding increase in rent, especially in these property classes.
The realization that the renovation investment was not worth the cost often comes too late, after substantial capital has already been expended without achieving the projected increase in rental income.
For a more strategic approach, compare the rent levels of your property with those of newer or higher-quality properties in the same area.
This comparative analysis can provide significant insights into how your property is positioned in the market.
If your rents are almost as high as those of better properties nearby, tenants have little incentive to choose your property over others.
This is especially true in markets where new property owners are offering reduced rents to attract tenants.
Therefore, it's important to strike a balance between renovation costs and achievable rent levels to maximize profitability.
Many investors focus on rent projections without thinking about the local cost of home ownership, which can be a crucial factor in the rental market.
If the monthly mortgage payment for owning a home is close to the cost of renting, tenants may lean towards buying rather than renting.
This consideration becomes even more relevant in markets where home prices have remained relatively stable.
In such markets, the likelihood of tenants choosing to buy instead of rent increases significantly—especially for property types that are direct alternatives to homeownership (like spacious townhomes or luxurious units).
To mitigate this risk, be sure to study local housing market trends in addition to rental rates. Understanding the comparative costs between renting and owning can provide critical insights into the sustainability of projected rents.
If the costs are comparable, you may need to adjust long-term rent projections downwards and develop alternative strategies to maintain profitability.
While key financial metrics like yield-on-cost, equity multiples, and cash-on-cash returns are often at the forefront of an investor's analysis, the property's basis—the underlying value of the property—should not be ignored.
Having a strong basis acts like a financial safety net, providing a layer of protection if investment fundamentals go south.
This is because a favorable price per unit or per square foot can offer some resiliency against market downturns or operational challenges.
As an investor, you need to conduct a thorough analysis to determine whether a strong basis exists, as it can act as a safeguard if things don't go according to plan.
The alternative is a precarious investment strategy that leaves little margin for error and makes the project far more susceptible to any unforeseen setbacks or market fluctuations.
By balancing their focus between yield metrics and the property's basis, you can create a more resilient and well-rounded CRE investment plan.
Understanding and avoiding these common underwriting mistakes is crucial for long-term success in multifamily CRE.
With thinner margins for error in today's economical and scape, being aware of these pitfalls could make the difference between a successful investment and a costly mistake.
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