“Conservative UW is Dead”

31 Replies

“Conservative underwriting is dead.”

Rob Beardsley brings up a great point. It’s extremely difficult to be an active real estate investor in this market if you are using extremely conservative underwriting techniques.

📈Values are inflated and deals are being listed for crazy prices. But yet, deals are still being bought and sold all around.

There are times deals do not pencil out to provide our required return metrics but then months later, I will see that deal being closed on LinkedIn and the buyers are projecting a 19% IRR. 🤔


📌Anyone else have thoughts on this? How is your team adapting to this competitive market and underwriting deals? 👇


Check out Rob’s video HERE

It's fake. Don't buy. If you can't underwrite it conservatively, then don't buy. The deal has to work. It has to have at least potential to cash flow. Wait. There will be plenty of opportunities. Maybe it won't be the same level of opportunity as 2010 because of the lending and fluctuations with interest rates, but there will be an opportunity nonetheless. This is not sustainable as renters don't have the money to have "rents pushed" on them over and over again. You can push your rents all you want, but if renters can't afford it, what good does it do? 

Also, the claim is that there is a shortage of available properties. This is true and not true. Our population growth is less than 1% per year and has been going down since about 1998. prior to that, it wasn't more than 2% per year. 

Most people don't understand how to underwrite in the first place, unfortunately. I've read through decks telling me a deal projecting 3% rent growth is conservative because the last 2 years rents grew at 3.5%. No research or data or description of supply/demand dynamics in the market. The entire thesis was 3% is lower than 3.5% and therefore its conservative. That's a pretty easy pass for me. 

When looking at deals and track records, I like to ask for a comparison of projected rents vs. actuals, projected NOI vs actuals, and projected exit cap vs. actual to get a sense for a sponsor's ability to underwrite vs. getting bailed out by cap rate compression. It definitely makes some people squirm.

Like you, I've seen tons of deals advertised with IRRs that anyone who is actually looking for deals in today's market knows are virtually unattainable and I wonder who the heck is investing in this stuff?!?!

To answer your question, integrity and trust are incredibly important. I think it is best to play the slow game here - talk to your investors, educate them about what is going on and walk them through a sample deal - Here's how we underwrote this deal and what the IRR was vs. what the other group did. Showing the how and why you PASSED can be a big trust building exercise.

Ultimately, they may wish to invest with you for a REAL 12% IRR vs. getting jerked around by some guy who used to be in marketing a year ago for a pie-in-the-sky 19% IRR.

Rob does a great job. I have had him on my podcast. Deals are super hard to land today but it is all about the amount of LOI's you write. The more you put out there the better chance you have at landing a deal.

My biggest issue not too long ago was when I was underwriting I was being conservative in EVERYTHING. Which made us not competitive at all. You have to pick and choose where to be aggressive and where to be conservative. Examples are areas like vacancy rate, concessions, bad debt, loss to lease, repairs, maintenance, marketing, turnover, capex budget, etc. Areas like exit cap rate is huge as to where you can "juice" that IRR. I think exit cap rate is the one you have to focus on as it plays a large roll in the project. It has to be realistic. Our rule of thumb is for each year we plan to hold the asset the exit cap rate will increase 10 to 25 bps from our acquisition cap rate depending on the market. NEVER will it go down unless its downtown Dallas or Fort Worth which we are not in that state but it is a good example.

@Justin G.

Good question.

So many people tout conservative underwriting to such a degree as to make it almost become a cliche. I can’t remember the last OM or IS that did not have the words “conservative underwriting” somewhere. I believe the term is mis-managed and over-used. To some degree, the term is more about marketing than analysis.

Just my opinion, I understand others will feel differently.

Many now believe cap rates are absurdly low and the market is way over-heated and best to do nothing at the moment (refuse to buy at a 4% cap, for example) and wait for the inevitable crash or bubble burst.

Since I don’t pretend to know the future, these folks may well be proven correct.

On the other hand, with negative interest rates in Europe today, who is to say a 4% cap isn’t the “new normal” for now and into the near future?

Investing for me has always been as follows:

1. Do the numbers work today? Does the purchase make sense today?

2. Based on best available data at the present moment, is there a reasonable rational logical reason to be optimistic about the property and its location moving forward into the future? (Understanding some of the data may be flawed and understanding the data can change rapidly.)

3. Any underwriting any projection about the future by definition involves assumptions about the future. If one doesn’t make assumptions, one can’t underwrite. So question 2 above can be directed at one’s assumptions. Are there reasonable rational logical reasons to make this assumption?

4. If the answers to these questions are Yes, then I invest.

At that point, hold onto your hat because life will unfold and the best any of us can do is to respond and adapt at what life throws us. Focus on what we can control because there is so much we can’t control.

To circle back to the original question, I don’t think “conservative” is really the thing. Any underwriting by definition is some one’s opinion as to what will happen. Whether that opinion turns out to be “conservative” or “aggressive” isn’t determined when some one completes their underwriting. That will only be known 5 to 10 years from now.

Don’t count the cards until the dealing is done.

The other point is underwriting is as much an art as a science. This is where some one’s intuition and life experience come in. All this data is analyzed through this filter. To some agree, the “artful” ability of the underwriter investor or syndicator is the key - the value judgements made about assumptions is critical. One needs to know the market, have their finger on the pulse of the market and community, the vibe what’s happening what’s likely to happen. The data is great but at some point intuition and skill come into play.

I don’t have the answers, just expressing my opinion, and posing some questions.

It’s a fascinating topic, no doubt.




@Justin G. as you, and others can see by the comments is conservative is in the eye of the beholder.  To use Phil's example: 3% is "conservative" when compared to 3.5%.  As to whether the investor reviewing the deals buys that is up to them.  I have friends that sent me a deal with a 5.25% going in cap and a 5.10% exit cap rate and made a case as to why they thought that was a conservative assumption.  I do think my friends truly believed the story they were telling, but I didn't.  Looking at the market today, that 5.10 is very conservative versus the low 4s people are getting today.

I would find it hard to believe any operator is going into a deal saying, "we are really going to have to push the market to hit these numbers".  Every investment manager will be able to spin why the numbers they are presenting are realistic, so it really comes down to does the investor buy the story.  And therefore, I disagree that "conservative UW is dead".  I just think people's perspectives of conservative have always been subjective. 

Underwrite to whatever your investment goals are and don't compromise. To my dismay I find there are reasonable deals happening reguarly, but I find out about them after the fact. An 8 unit just closed in my market and I really liked that building but I had no idea it was for sale; it was completely outside my dealflow. There was no broker involved on either side and it would have met my criteria! Guess I'll have to take up golf!

@Phil McAlister Exactly! I’m wondering who is investing in these projects. Deals are still being sold everywhere. Great points. I would rather be more concerned about my reputation and the investors capital. 

A lot of good replies here! The quote that resonated a just bit more for me on the topic (by @Arn Cenedella ):
"So many people tout conservative underwriting to such a degree as
to make it almost become a cliche. I can’t remember the last OM or IS
that did not have the words “conservative underwriting” somewhere. I
believe the term is mis-managed and over-used. To some degree, the term
is more about marketing than analysis."

I can't help but concur 100%. "Conservative" being mentioned in a PPM or presentation (especially repeatedly/often) with only anecdotal justifications at best, can quickly be a yellow flag. Not really a calming effect for some. Similar to "it's a good deal" from your brother's Fund Advisor. Sometimes it is a good deal, yet most often it's only a pitch of requisite words to try and install a sense of comfort. Maybe because "everyone" is doing it.

Originally posted by @Phil McAlister :

Most people don't understand how to underwrite in the first place, unfortunately. I've read through decks telling me a deal projecting 3% rent growth is conservative because the last 2 years rents grew at 3.5%. No research or data or description of supply/demand dynamics in the market. The entire thesis was 3% is lower than 3.5% and therefore its conservative. That's a pretty easy pass for me. 

When looking at deals and track records, I like to ask for a comparison of projected rents vs. actuals, projected NOI vs actuals, and projected exit cap vs. actual to get a sense for a sponsor's ability to underwrite vs. getting bailed out by cap rate compression. It definitely makes some people squirm.

...

Ultimately, they may wish to invest with you for a REAL 12% IRR vs. getting jerked around by some guy who used to be in marketing a year ago for a pie-in-the-sky 19% IRR.


Phil, have you normally been able to get the comparisons delivered, and what is the success rate of the requests? Timely and thorough?

 It seems uncommon to see a sponsor so transparent as to boldly list the full data upfront w/o one asking: all deals, all full cycle outcomes, and all held deals WITH "Deal to date" results vs original PPM projection. Good to see, and better yet if they have a meh/dud/bad deal in the mix. A perfect record can be a warning flag or risk rating factor.

@Evan Polaski I agree the ‘story’ can be a big component of the deal. But numbers don’t lie. I can see how presenting the story is important but the underwriting is what will determine how realistic and achievable the story/strategy is. Great points!

@John Sayers I work on larger deals with institutional grade sponsors for the most part, and they're sophisticated enough to "get it" and will provide essentially whatever info we request as part of our DD process.

We do get packages from smaller players looking to step up into the space, and those are usually the guys we beat up quite a bit and that usually try to skirt the issue a bit more.

We call these guys the "boot camp guys" and we get a laugh out of exposing their lack of experience and expertise when it comes to institutional grade deal making vs. syndicating to retail investors who don't know any better. They go from being the all knowing expert to the stammering rookie pretty quick...

I agree with @Jillian Sidoti . Unless you can find creative find ways to increase the value of the asset, you shouldn't change your investment criteria or make it malleable in order to make the deal work. This puts your investor's capital and your own reputation at risk.

Originally posted by @Justin G. :

“Conservative underwriting is dead.”

Rob Beardsley brings up a great point. It’s extremely difficult to be an active real estate investor in this market if you are using extremely conservative underwriting techniques.

📈Values are inflated and deals are being listed for crazy prices. But yet, deals are still being bought and sold all around.

There are times deals do not pencil out to provide our required return metrics but then months later, I will see that deal being closed on LinkedIn and the buyers are projecting a 19% IRR. 🤔

📌Anyone else have thoughts on this? How is your team adapting to this competitive market and underwriting deals? 👇


Check out Rob’s video HERE

We put together deals and invest alongside LP's in a very competitive coastal market (Los Angeles). We underwrote very conservatively relative to what we had done in previous deals and what the market bears, and using those metrics, showed an IRR of slightly under 11%, on a long term hold.

We had great interest in the deal, but I had a few LP's tell me that they were not interested because some guys were sending deals with 19% to 22% IRR mostly out of state, and they were believing these crazy numbers. At first, I was a little disappointed, but I realized that I can live with it.

We'll likely beat the IRR we listed by a decent amount, and will definitely cash flow well. More importantly, the investors who can with us are realistic in their goals, and want to work with an honest operator who will preserve capital. I have definitely seen that building such trust means you'll sleep at night, and have referrals to more investors in the future.

I suspect many of the deals we're seeing are being pushed because of low rates, and lots of people joining the syndication bootcamps, and figuring that they can do it. As a result, there are a lot of bad transactions getting done. Most of these won't end up in foreclosure of course, but the investors will get mediocre returns and be disappointed. 

So it goes I suppose. Smart underwriting is the only way to preserve wealth long term.  

@Shiva Bhaskar Thanks for the reply. It’s always best to under promise and over deliver. It’s certainly possible that many of these deals that we see going on will not provide the huge returns they are projecting. It’s really important to ask questions and carefully evaluate the operator. 

@Justin G. , I disagree and think the numbers can very much lie.  Getting those numbers is an art not a science, and therein lies the story and the subjective nature that goes into underwriting.  

Back to my friend's: they presented real data to support their numbers: comp sets, co star reports, etc that showed their numbers were conservative.  But that doesn't mean I agreed with their outlook, even though they had numbers to support their numbers.  And their numbers came out to some strong returns.


I love this thread.  We are underwriting 25-35 deals a month for Florida.  Since we only invest in Florida, I don't know about the rest of the country; but vast majority of don't pencil.  The change from agency to bridge is indicative that "conservative underwriting is dead." :)  Should I do a podcast episode on this to go deeper on the topic?

Originally posted by @Mike Lorence :

I love this thread.  We are underwriting 25-35 deals a month for Florida.  Since we only invest in Florida, I don't know about the rest of the country; but vast majority of don't pencil.  The change from agency to bridge is indicative that "conservative underwriting is dead." :)  Should I do a podcast episode on this to go deeper on the topic?

The problem with all of this is that first, you only know for certain in the rear-view mirror, and second, terms like "conservative", "aggressive", and the like are totally subjective and depend on who's using them and in what context. Is 5% rent growth "conservative" if everyone else is using 10% projections? What about if 2% is the historical norm? Does the "conservative" view encompass all possible knowable information about other economic factors, political considerations, natural and man-made exposures, and the like? 

Everyone's master copy to which they compare all deals is dependent largely on their own biases and to a lesser extent whatever information is reasonable to know or to obtain.

PS: I love this thread as well. It's an interesting topic and probably something that's not covered here enough as we spend a lot of time on beginner material here at BP.

I work for a local lender and a ton of deals are getting killed once the appraisal or banks underwriter gets to them. We see borrowers projections and it's beyond rosy. Applying a 3% vacancy/credit loss rate to a retail strip, where the market data indicates 6-8% vacancy for the past ten years and the property has historically had significant turnover. Assuming 3% rent growth is fine if it coincides with market demand in that area. Some of these markets have declining populations for the past few decades. With no support that this trend would turn around? I agree with one of the above posters. It does appear to be new entrants into the syndication business pushing these deals onto retail investors who look at the Projected IRR and that's the extent of their due diligence.

With all that being said. I would always fall on the side of being more conservative myself. Yes, you will most likely pass on a ton of deals. But the ones that can pencil out will not disappoint. 

@Evan Polaski

There’s an old expression about numbers and it’s GIGO - garbage in garbage out.

Numbers in a spreadsheet can be tweaked incrementally but produce large differences in returns.

At the end of the day, it is the skill of the underwriter and not the excel formulas that really count. And that skill is primarily tied to local market knowledge.

When an underwriter has to decide: Does a $5,000 value add renovation add $100 or $125 or $150 to the rental rate of a unit? What’s the rent bump if any for granite over laminate? These type of questions are the key to the analysis. 

I’m an old school guy and still carry around and use an HP12C calculator I bought back in the early 1980s while doing my CCIM coursework. I don’t see spreadsheets as the ultimate answer.

Here is maybe away to look at this.

If one was buying an asset 1000 miles from their home......

Which analysis would you trust more?

An analysis from someone who doesn’t own an asset in the area, visits for a couple days and then dives deep into Costar and then underwrites the deal.

OR

An analysis from someone who owns five similar assets in the area and then uses their own verified income and expense data complied from their five other assets plus their actual experience in the market where they KNOW what value adds produce the best returns in that market after several years of actual trial and error. They know the market (and minor local area nuances etc) they know what appeals and what doesn’t. They know precisely what it costs to paint a unit because they have painted hundreds in that market. 

In my mind, the answer is obvious.

Costar is great but often contains errors. I recently looked at an asset and Costar said 763sf units. Actual measurement revealed 610sf.

There no right answer here and in some ways, we all are saying similar things - I think we all agree the data is important. The question is where do you get the data from and how accurate it is.