How My Underwriting Has Changed in 2022

The multifamily market is starting to shift. If you’re a seller, then you probably have not yet come to terms with this as you may still trying to capitalize on the aggressive pricing the asset class has experienced over the last several years. Yet, for the sophisticated buyer, the writing is clearly on the wall; with the new interest rate environment we are in, asset pricing must shift. With this shift must also come a new way at analyzing new opportunities, as assumptions that we made even last year may not necessarily be valid anymore.

Let’s hone-in on how multifamily underwriting needs to shift given everything going on in the new environment. I’m going to focus on three metrics that I have a lot of sensitivity in any underwriting model: cap rates, interest rates, and rent growth rates. 

For cap rates, my logic is pretty straightforward and should not surprise most folks that have been studying the real estate market; I believe they are going to decompress. I’m already starting to see that, and as the new interest reality keeps sinking in, it’s just a matter of time until market cap rates start to shift. Even in the most desirable markets, at some point once the cost of debt gets too high, investors will have to shift their return expectations to accommodate. Thus, in all my models, I’m now starting to bake in an extra 1-1.5 points on the exit cap rate for any 3-5 year hold-project. It’s certainly been making our offers less competitive (as our back-end values are much lower), but as a responsible investor and someone managing quite a bit of investor capital, I have to protect the downside.

The second factor which should come as no surprise that needs to be adjusted is the interest rates. On the front-end, it’s pretty easy to implement a higher interest-rate assumption on the debt you’re borrowing for the acquisition. However, for those doing any value-add projects that have a refinance component, you’ll want to consider the interest rate assumptions on your refinance debt as well. This will be critical especially if you’re using any sort of bridge-debt or have a large chunk of capital you need to pull out of the property. With higher interest rates on your refinance debt, your back-end debt service overage ratio (DSCR) will also tighten up, so make sure those numbers still look tight.

Finally, the last factor you should consider is rent growth. The rental market in most areas across the US has rebounded quite nicely, and rents are very strong today. Some markets, particularly those in the south, have even been experiencing incredible double-digit year over year growth in rents. Yet, with financial turbulence likely coming in the near future, it’s important to not get past years’ performance impact our judgement of the future. Now, I still certainly would encourage all investors to invest in markets where they do anticipate future rent growth, but baking these assumptions into an underwriting model and having that be a key driver in returns is certainly playing with fire.