Deal or No Deal: The Underwriter's Playbook

[Jorge Abreu]

Underwriting deals is an essential aspect of real estate investment. It's all about analyzing the financials and understanding the numbers of a property. You need to know the existing performance and project the value you can add to it. It's a numbers game, and realistic assumptions are key.

Cap rates play a significant role in property valuation. They determine the property's worth based on its net operating income divided by the purchase price.

Understanding cap rates requires analyzing market trends and recent transactions. For example, if a deal closes at $100,000 per door for a $10 million property, the cap rate is $100,000 divided by $10 million.

To quickly analyze a deal, I use the 1% rule. If the asking price is $100,000 per door, I expect to see at least $1,000 of average monthly rent per door. This rule provides a quick assessment, but detailed underwriting is necessary for accuracy.

Now, let's break it down further. There's the going-in cap, which is a quick snapshot of the property's potential. We calculate it by dividing the trailing 12-month net operating income (T12 NOI) by the purchase price. It's like taking a sneak peek into the future profits. We also have a target in mind (e.g., a 6% cap rate). Why? Well, that's because it would be ideal for our investment strategy.

Here's some math: if we have a property with an income of $1.2 million, and we subtract 50% for expenses (because, hey, life happens), we're left with $600K in net operating income (NOI). We divide that lovely NOI by the property's value, let's say $10 million, and voila! We get a 6% cap rate.

Let's talk about the adjusted going-in cap. It's like the going-in cap but with some tweaks. We adjust it to account for possible changes in the property's income or expenses. It's all about making sure we're not missing any surprises along the way. Got to be prepared, right?
Let's say you're eyeing an apartment building with a purchase price of $5 million. The trailing 12-month net operating income (T12 NOI) for this property is $500,000. In this case, we take into account some potential changes in income and expenses. Let's say after a thorough analysis, you estimate that the income might increase by $50,000 per year and expenses might rise by $20,000 per year.

Here's the math: we start with the T12 NOI of $500,000. Then we add the expected increase in income of $50,000. This brings our adjusted net operating income to $550,000. We also need to account for the increase in expenses. We subtract the expected rise of $20,000 from our adjusted net operating income, leaving us with $530,000.

Now, let's calculate the adjusted going-in cap. We divide our adjusted net operating income of $530,000 by the purchase price of $5 million. What do we get? Drumroll, please ... an adjusted going-in cap rate of 10.6%!

So, there you have it! The adjusted going-in cap rate gives us a clearer picture of our potential return on investment, taking into account those sneaky changes in income and expenses.

However, underwriting deals is not without pitfalls. Many people make mistakes when underestimating renovation costs and overlooking the time and process of renovations. It's crucial to allocate sufficient funds and consider the impact on vacancy rates. Assumptions on taxes and insurance are also common mistakes. Proper research and expert advice can prevent these deal-breakers.

Detailed underwriting and stress testing are essential. I believe in the philosophy of “killing a deal.” It means critically evaluating its viability and identifying potential risks. Our job is to find ways to damage the deal by stress test occupancy rates and exit cap rates to ensure we can cover our debt service, even in challenging scenarios.

Underwriting deals involves different stages, and I recommend using a model or spreadsheet to streamline the process. It saves time and enhances accuracy. However, developing underwriting skills takes time and experience. It's a continuous learning process that evolves with market conditions.

In summary, underwriting deals requires a thorough understanding of the financials, realistic assumptions, and market trends. It's about analyzing existing numbers, projecting value, and using cap rates for property valuation. Avoid common pitfalls and always stress test your assumptions. The goal is to “kill a deal” and ensure its viability before moving forward. Streamline the process with models or spreadsheets and embrace the evolution of underwriting skills through continuous learning.