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Real Estate Investor Series Part 4: Conservative Underwriting

CONSERVATIVE ANALYSIS. This is a term often used by real estate investors and especially syndicators. However, what does it really mean to be conservative?

The dictionary defines conservative as "purposely low for the sake of caution."

When underwriting, are you doing ENOUGH? If you underwrite just under the average, is that conservative enough? Maybe, but should you consider going even further?

Some questions to ask yourself when doing a conservative analysis include:

  • How low are you going for the "sake of caution" in your analysis?

  • Are you building in only physical vacancy in your underwriting? What about economic vacancy factors such as loss-to-lease, bad debt, and concessions?

  • How about the income and expenses you are using?

  • What about cap rates? What are you using for the cap rate now versus the future cap rate for a refinance or sale?


One area of conservative underwriting often overlooked is the economic vacancy of a property. It’s common to hear about building in physical vacancy in a property as that is when a tenant is not currently physically occupying your property. This is simple to calculate as the number of days unoccupied divided by the number of rentable days. A 5% stabilized physical vacancy is a number often thrown around and can be higher or lower depending on your market, the neighborhood, and the property.

Economic vacancy differs from physical vacancy because in most of the cases, a tenant is currently physically occupying your property but your loss is economic and is not fully maximizing rent collection. Economic vacancy factors often include: loss-to-lease, bad debt, concessions, and non-revenue.

LOSS-TO-LEASE: This is the difference between potential market rent and the rent currently being paid by the tenant. For example, if your tenant is paying $500 but the potential market rent is $525, then your loss-to-lease is -$25. You are losing this money on paper every month the tenant is not paying market rent.

BAD DEBT: When a rent or fee from a tenant becomes uncollectible because either the tenant is unable to pay it or they move out or are evicted and do not pay.

CONCESSIONS: This includes move-in specials or other discounts given to a tenant in the short-term. If they become long term concessions, then they can be moved to loss-to-lease.

NON-REVENUE: These include units converted into a leasing office or maintenance area, unrentable due to heavy rehab needed, and units used as a model.

As it can be seen, in many of these cases a tenant is physically occupying your property but the potential market rent is not being collected. On paper, these will be considered economic losses.


A second area of consideration in conservative underwriting are the income and expenses.

When it comes to income, are you being too optimistic in the rental income or other income categories? For example, if you know the potential rent ranges from $750-$900, are you using the top potential number, the lower number, or somewhere in between? If it’s the higher number, then you should be certain you will consistently be able to get that.

I’m often asked where estimated rents can be obtained. There are many websites out there who can give you an estimate, such as rentometer or BiggerPockets. I’ve noticed many times the rent is all over the board. I’ve found the most accurate numbers from speaking with local property managers who have a finger on the pulse in the local market. It’s wise to speak with multiple property managers if possible as their range can also be all over the place, but generally they are in the vicinity of each other. Rent is really subjective and is based upon what the market can bear.

Expenses are another area where it is easy to be too aggressive with analysis. When reading the offering memorandum (OM) or listing for a property, it is not uncommon to see the seller or seller’s agent provide financials for the property. Many times, these are pro forma financials, meaning an estimate of the potential. I’ve also observed many times not all expenses are being included in the pro forma. You should have at least the following expenses included in your analysis:

Payroll (if applicable)

Contract Services

Repairs & Maintenance






Management Fee

Property Taxes

Replacement Reserves

Franchise Taxes (if applicable)


The capitalization rate or cap rate is often spoken about in real estate and even more so in commercial real estate. The cap rate is a semi-arbitrary number used with the income approach of valuation for a property by dividing the net operating income by the cap rate.

For example, if your net operating income is $200,000 and the cap rate is 8%, then the value of your property will be:

$200,000/8% = $2,500,000

If the net operating income remains at $200,000 and the cap rate is 7%, then the value of your property is now:

$200,000/7% = $2,857,142

The only thing that changed was the cap rate which gave you an extra $357,000 in value.

Is the cap rate an accurate way to evaluate the true value of a property? No. More about the cap rate will be covered in a future post.

Depending on several factors of the property you are evaluating, including but not limited to property condition, location, and class, the local market will have some sort of cap rate range. The better the property, the lower the cap rate. When doing your conservative analysis, are you using a conservative enough cap rate? You should inquire with local brokers or investors on market specific cap rates. Even neighborhoods within a market can have varying cap rates, so make sure you ask multiple sources.

When it comes to refinance and exit cap rates, the common rule of thumb is 10 bps (or 0.10%) increase in cap rate per year the property is held. So if you hold a property for five years and your purchase cap rate is 7%, then you will use 7.5% as your exit cap rate.


Conservative analysis is a very subjective term with no systemized process to complete it. Depending on the market cycle, it may be necessary to be slightly more aggressive with your analysis or else nothing is going to pencil out. It is a delicate balancing act with no one right way to get it done.

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