Underwriting Deals: 3 Lessons
Many of you know I’m a deal junkie. Ever since I bought my first property, I was hooked. And I spent the remaining years since 2015 sharpening my deal underwriting ax to become better, faster, and smarter at how to underwrite deals. Underwriting is all about using available data to make an educated decision on what will happen in the future. These 3 lessons, applied to your underwriting model, will have a dramatic impact on the project and investor returns. Mastering these lessons in your underwriting is paramount to being a successful investor.
Forecasting Rents
The first lesson is understanding and forecasting projected rents.
Your rent amounts have a huge impact on the overall returns of a deal. For example, if you are projecting to achieve a 10% rent increase, you should be certain this is realistic based on the available data. Even small changes in rent premiums can have a huge impact on the performance of your project. The best way to have confidence in your number is to verify market rents with a local property management company, check whether household income in the area can support the higher rents, and use third party data sources like Costar.
Financing The Deal
The second lesson is understanding your financing. Leverage can make a huge difference in your returns. So choosing the right financing for your project can often determine its success. We’ve been spoiled lately with historically low interest rates. So shopping all of your options to get the best rate and terms may determine if your project turns out to be a good deal or not. I’m seeing more and more deals fall apart because the cost of financing is too high.
Also remember that financing is more than just the interest rate. We want to understand the impact of all the variables, such as amortization schedules, balloons, rate cap fees, origination fees, and extension fees.
Getting to know local lenders in the local market can be extremely helpful. Believe it or not, there are creative bankers that will make suggestions on how you can finance a project in order to make it work.
Making Assumptions
The final lesson is to interrogate all of your assumptions and stress test them to see what the break-even point is for your project. Many investors grossly underestimate ongoing operating expenses and vacancy rates. It’s not a good idea to assume a very low vacancy rate and then get surprised to find out that you must have a 5% occupancy rate in order to break even. That leaves very little margin for error and makes investing far more stressful than it needs to be.
I’m also very wary of a project that only works in optimal conditions, like steady rent growth for 5 years. I like to know a deal works at the current market rate and doesn’t require a huge rent increase for the deal to check out. Play these numbers very conservatively and plan for the less than optimal outcome to ensure you can weather a downturn or bad luck. Any assumption you are making should be verified by 2 or 3 different sources instead of cherry picking one data point that tells the story you want to see. You will do far better in business if you get in the habit of following these lessons and playing the long game where you under-promise and over-deliver.
Join Me at rewbcon24 In SAINT LOUIS, mO
I’ll be speaking at the Real Estate Wealth Builder’s Conference on March 14th-16th. Book your tickets REWBCON. Network with investors and hear speakers from all over the country. Don’t forget to use my promo code ‘RE101’ to get 50% OFF your ticket.
I want to get together with you and all the other investors from my community at the event. The Real Estate Wealth Builders Conference will be here before you know it. So don’t want to miss out!.