How Aggressive Underwriting Can Destroy Your Multifamily Investment

How Aggressive Underwriting Can Destroy Your Multifamily Investment

In today’s multifamily space, you have to look at twice as many apartment offerings to find one that pencils out. Whereas in the past where 1 out of a handful may check out, today, it could be 1 out of 100 deals and beyond that actually make sense. This is due to the competitiveness of the multifamily space.

The High Competition of Multifamily

More people are switching asset classes, leaving paper investments (stocks, bonds, etc) and looking for real assets (real estate). Even international investors are investing in apartments in the United States. What is that doing to price? It drives them up significantly, meaning cap rates are compressing (higher price means lower cap rates).

So how does one stay competitive in this environment? In other words, how does a sponsor or investment firm actually get a deal? Well, they have two, maybe three, options. The first is to stick to their investment principles and criteria and the second is the exact opposite, pay what sellers demand. Before we talk about the third option, let’s discuss these first two.

Staying Principled In a high-demand market

This actually sounds really wise, and it is. Except, one may miss out on some really good deals. If today, prices are high, we have to ask, “compared to what?” Compared to last year, for example, the price of real assets in a certain market are high, perhaps from a cap rate perspective. But does that mean that we should not buy anything? Probably not. Sticking to a rigid set of criteria can cause one to miss out on great investment opportunities because they missed one important thing: there may still exist opportunities to grow a properties value by value-add and sell it at a profit a few years from today.

Pay Today’s Prices for A Multifamily Asset

While sticking to the sidelines altogether may not be the best option, simply paying what sellers ask is certainly not the answer either. First of all, lenders would not lend for it (if the underwriting does not check out). Secondly, it can destroy your investment. For example, if a property is overpriced because it will not cash-flow at that price or based on its income, the investors can be in trouble. No matter how you spin it, you can simply be depending on too many factors to “someday” make it a worthwhile investment. I caution against this. Unfortunately, many people are aggressively taking deals like this right now and it is very likely that they fall short of their business plan for income growth or for the sell price (if the basis for the investment was the assumption that they could sell the asset for that much more than they acquired it for).

The Middle Ground: Underwrite Based on Near-Term Improvements

Now, here is the third option. What if, instead of waiting for a “better market” or buying at ridiculous prices, a sponsor or firm factored in some easy growth opportunities, while still being conservative, which allows them to justify paying a higher price today for an asset? Here is an example.

Let’s say a 100-unit apartment is discovered to be considerably below market-level rents. It has average rents of $900 monthly but due to local market knowledge, the team knows that they can easily raise rents to $1,000 without any actual improvements to the units. Rather than underwrite at the lower, current rental income, the team could underwrite based on a projected higher income level based on the easily achievable raise in rental income from new leases or renewals within the first year. Simply put, the underwriting will reflect higher net operating income, and based on those levels, justify paying a slightly higher price for the asset. As a reminder, the team can still be conservative with regards to rent growth projections, but based on this special knowledge of the lower-than-market rents, those details can be factored into the opportunity.

Work with Experts

This middle ground may work well in today’s competitive market and certainly works well when a sponsor has specialized market knowledge that allows them to see opportunities other investors may not identify.

If you are considering passively investing in apartments, ensure you are working with a highly-capable and competent sponsor. Check out our Passive Investor Startup Guide, which includes effective tips for vetting potential sponsors for your next investment.

Passive Investor Startup Guide

To find out more about what it looks like to invest as a passive investor in multi-family real estate, download our free Passive Investor Startup Guide here!

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Rodney Robinson II

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