The term “conservative underwriting” is thrown around so much that it has lost a lot of its significance. It is also a very subjective term where no real threshold exists to make something "conservative". The dictionary defines conservative as "marked by moderation or caution".
So how cautious (conservative) should you be? Be too cautious, then you will probably find every potential opportunity to be too risky. On the flip side, if you are not cautious enough, then you may be too aggressive and overlook blaring red flags.
In today’s post, I want to break down how we underwrite our deals into general steps to ensure we stay "conservative". Every deal is different and has its own unique challenges; however, below are the steps we take when underwriting every deal.
First, when looking at rents, we will pull rent comps of similar units and look at the price per square foot. We'll speak with multiple property managers to get their opinion on rents and value of the property. We'll usually get a rent range and we will typically take the lower end of that range to underwrite the property.
Second, we'll look at economic vacancies. This includes vacancy, loss-to-lease, bad debt, and concessions. To get to these numbers, we will look at the T12 of the property and the historical market averages. Our total economic vacancy is usually between 11%-13%.
Third, we look at expenses. Again, we look at the T12 and discuss with the property manager where average expenses typically are in a similar property. We look for areas where we can reduce expenses, this many times can be with utilities, administrative costs, renegotiating contract services, etc. Many times, we have to raise expenses in some categories to maintain "conservative" and to bring the property up to our standard.
Fourth, where can we add income-producing items? This can include implementing RUBS and adding amenities, such as laundry, storage, etc.
Fifth, we will look at the type of lending we can get. We'll add a few basis points to the rates we are being quoted by the lender just in case the rates jump during our acquisition process. We'll also keep a healthy cash reserve of around 6 months of debt service.
Sixth, we will look at the capitalization rate (cap rate) of the property. What is the cap rate for other properties in the area? Because it is nearly impossible to use comps of other commercial properties, the cap rate is one of the primary ways properties are valued. The reason comps are not used is because no two properties are the same. The difference in floor plans, amenities, square footage, and location all result in different rents for a given property. There are just too many differences between properties to use comparison sales as an effective method of valuation. We will increase 10 bps (or 0.10%) in cap rate per year the property is held in order to stay conservative.
The steps above outline our general underwriting steps. Every opportunity is different and the approaches will be different as well. Through experience, you will learn how to tweak the numbers that will make the most impact on the overall returns of the deal. This is a double-edged sword as an underwriter can manipulate the numbers to look like sunshine and rainbows if they are overly aggressive. Pushing the limits on the underwriting may be necessary to get a deal to work, but be wary of what is manipulated and how far it is pushed. Underwriting is an art and not a science.