Underwriting concerns/formula more of a deep dive.

7 Replies

Good Afternoon BP,

I am currently working on getting a feel for underwriting and I am crunching numbers on multiple properties. The wife and I closed out or real estate and we are look to re-invest in the first to mid point of 2020.

The issue I am having is in underwriting and I am wondering if I am being too conservative. My underwriting is as follows:

-10% for VacRate (changes depending on the market)
-10% PM (changes on size of property or what is stated in the OM)
-10% Repairs
-10% CapEx

= Cashflow

This is the basic building blocks of my underwriting and I expand upon these.

Such as looking for ~1.25 DSCR for bank underwriting purposes and time to 6 months worth of reserve.

The issue is that most properties listed are not reaching the very basic 1.25 DSCR that would be required by lending institutions with current asking price and NOI. Because of this I am questioning that my underwriting might be too conservative and I am really pricing myself out of some deals.

So my question to the community is as follows, given the above information am I too conservative with my underwriting? If I am what numbers do you use?

If I am not being overly cautious and it is the seller who has unreasonable expectations. What do you successful buyers do to get the property more in line with lending standard or your own personal standards? At what time during the process do you start to nudge that price down etc?

10% for vacancy (assuming physical + loss to lease) is OK. The rest of the expenses are dollars, not percentage of rents, with the exception of the PM fee. 

You are also missing the following expenses:

  • payroll (this is different from PM fee!)
  • general & administration
  • contract services
  • make-ready
  • utilities
  • replacement reserves
  • marketing
  • insurance

On a revenue side, you miss "other income" - fees, covered parking, pet rent, laundry, utilities bill back (RUBS), etc.

@Michael Randle you should be underwriting the deals based on actual expenses supplied by the seller or listed in the OM. Expenses will vary greatly depending on the property. Also the DSCR will vary and can be increased using more equity and interest only debt which is how a lot of more aggressive deals are getting done.

Always best to air on the side of conservative as you will always have unexpected things pop up no matter how thorough your analysyis.

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@Nick B.,

If the majority of expenses are dollars vs % then each property, and each location/market would have different dollars assigned to a property. Class A in Miami would be considerably different than a class D in Chicago. That would lend me to believe that you focus on one market, (very reasonable) but you would very early run out of deals to analyze, especially in medium sized markets. As for what I am missing etc, most of the places I am generally looking at are small enough to not need those expenses, (self admin, insurance already added into formula etc) or command that type of premium.

But I would classify 'contract' and 'make ready' to fall under either CapEx or Repairs depending on what exactly is being done. Which is another reason I went with more of a % based formula vs just numbers. But I also have money set aside for 6 month reserve.

@Greg Dickerson, Thank you for the advise. What really brought this to my attention was analyzing and actual expenses supplied by the seller. He has listed about ~$3,000 per year in repairs for a 12 unit apartment build in 1923. Given his expenses the property would be a decent buy but in my mind if that little money is being spent on repairs a year it would seem that there might be more delayed maintenance and eventually I would have to pay it. That is why I was leaning towards my numbers to get a more accurate financial picture on what to expect on CoC ROI Cash Flow etc.

I am not totally sold on interest only loans but I can see how that would allow you to be more aggressive.

@Michael Randle,

I'd like to reiterate this again: Expenses are dollars and not percentages of rent (except for PM fee). Why? Because they do not depend on rents. If you pay $200/unit for general admin and the rent is $700, what do you think you would pay if rent doubles? The same $200. The same logic applies to any other category: If it costs $300/unit for a make-ready, it does not matter if that unit rents for $600 or $800 or $1200.

You are right saying that these numbers are market and property class specific (some more than the other). So, where do you get them from? For a high level estimate, NAA survey is good enough. It has a breakdown by region, category, unit, sq foot, property class, etc. For a detailed estimate, ask a few management companies that manage comparable properties. They'll give you much closer to reality numbers.

"Make-ready" is what happens after a tenant moves out but before a new one moves in. It is mostly cleaning and cosmetic repairs.

"Contract services" are something that is outsourced to 3rd parties. E.g. pest control, landscaping, trash removal to name a few.

Neither one of these categories are CapEx. An example of CapEx would be a new A/C or a new roof - something permanent with a long lifespan.

@Michael Randle @Nick B. is giving great advice.  A lot major players will break their expenses down into several categories $/sqft, $/door, %/sqft etc.  It is best to utilize a system that works best for you.  Since I come from a property management breakdown, my brain tends to think in average price per sq ft or average price per door.  These numbers change from property size, type and location.  

I would recommend getting to know someone who is involved in either the National Apartment Association, or my personal favorite is a CPM® member with IREM (I have credentials with both the NAA an am a CPM®). Being associated with these organizations allows us access to all sort of data. For example, just recently got the Income/Expense report from IREM. I can break it down by region, property type etc and get really detailed information to make the best informed decision for myself and my clients.

@Michael Randle it really all depends on the quantity of units what you're expense ratio will be to your GPI   Normally to stay conservative you want to underwrite using the 50% rule until you can determine from further research how much in repair and commonality expenses as @Nick B. was saying. You want to determine this with your experienced local PM of how property's are performing in that area. What are the avg expenses per door, so forth and so on

@Michael Randle Expenses are what gave me fits when I first started looking at properties because if you're new, you don't know what you don't know. I did two things.

1. Went through every OM I could find in my market and started making a spreadsheet of OPEX amounts, property class, number of units, OPEX ratio, etc. You'll eventually start seeing patterns emerge and you can gauge a dollar amount per unit. 

2. Called reputable property managers in the area and told them I was looking at a specific size/class of building and got their estimates on what it would take to run the building. These are the people doing it everyday and have a good idea on what expenses should be.