Especially in this economic cycle, the assumptions we make in our underwriting can lead to very critical miscalculations if we are not prudent and conservative. Below are two very important considerations in conservatively underwriting multifamily investments.
Rent Growth
Both experienced and inexperienced investors alike may be inclined to project rent growth in year one. While it is possible to execute 2%, 3% or 5% increases within the first few years, unless the asset is significantly below market value or under managed, it is most prudent not project increases for year 1 and 2. From that point, include modest increases (2%, 3%) over the next few years.
Another approach is to review both scenarios, one which is possible and one which is conservative. For example, if the asset is under managed and rents are well below market, for your own purposes, project 3% in the first year and 3-5% thereafter; however, as you officially underwrite and assess the possible returns, the more conservative approach of no increases in the first few years and small increases from there allows for upside to a reasonable target.
Terminal Cap Rate
The terminal cap rate is the cap rate at which the eventual sale is projected. This assumption is important because it directly influences the sale price and investor returns. Because no one is all knowing and cannot predict with perfect precision what the terminal cap rate will be, it is important to remain conservative by projecting a higher terminal cap rate than that at which the asset is acquired.
For example, if the asset is acquired at a 6.5% cap rate, even if you believe the market will continue to be hot and demand and prices will continue to rise, rather than project a 6.5% cap rate or lower, you conservatively estimate a cap rate that is higher by 50 basis points, or 7%. This leaves the possibility of being pleasantly surprised and doing much better for investors, but not the expectation.
The Conservative Approach
As you can see, conservative underwriting accomplishes two things:
1) Allows the prudent investor to calculate the potential upside in a deal, but prepare for less
2) Ensures that there is a margin of safety in the deal for all investors
3) Creates trust with investors as targets are more often achieved.
Especially in the economic time, it is important to be conservative in our underwriting. With the COVID pandemic, employment may continue to impact tenants’ ability to pay rent, which is why projected rent increases should be modest. During this economic cycle, the continued increase in prices of real estate assets my slow in your area and the cap rate could rise, which is why conservative terminal cap rates should be used in the analysis.
The cautious investor recognizes potential upside in the investment, but conservatively plans for the lesser outcome. If the deal with much upside works for investors using the conservative underwriting, it is likely to be a great deal.
