Underwriting Adjustments During Recessionary Times

As we face the possibility of a looming recession, along with rising inflation and stubborn interest rates, the real estate market may soon offer increased opportunities for buyers. Property prices might stabilize or even decline, potentially leading to a surge in available properties. In times of economic uncertainty, it's crucial for investors to adopt a conservative approach to underwriting. However, amid these challenges, there are promising opportunities to be seized. Here's how you can adjust your underwriting strategy in response to these shifting dynamics:

1. Adjust Exit Cap Rates

Think of this as your secret sauce for deal success. If you're eyeing a refinance, sale, or any capital event, tweak your exit cap rate. With interest rates poised to climb, it's like foreseeing a leveling of the cap rates playing field. While the extent of this adjustment will vary based on market conditions and asset class, a conservative approach involves factoring in a quarter-point adjustment for each year you hold the property. This adjustment acts as a safeguard against potential valuation decreases during a recession or continued interest rate hikes.

1. Adjust Interest Rate Expectations

Strap in for the interest rate rollercoaster. Given the anticipated increases in interest rates, factor in a quarter-point interest rate hike on your initial rate until it's locked. Additionally, if your business plan includes a future refinance, underwrite for further interest rate hikes. Relying solely on today's interest rates for future refinancing could distort the deal's profitability.

1. Decrease Income Growth Projection

Let's dial down the hype on rent growth. While recent years witnessed significant rent growth driven by inflation and supply constraints, it's prudent to temper income growth projections. While certain markets may sustain robust rent growth, it's more realistic to adjust projections to align with historical levels. Underwriting at lower growth rates, such as 5% or 7%, reflects a cautious approach that acknowledges current market realities.

1. Decrease Occupancy Projections

Similarly, occupancy rates surged in recent years due to shifts in consumer behavior during the pandemic. However, relying on peak occupancy levels may not be sustainable in the long run. Reverting to historical occupancy figures provides a more prudent underwriting approach, guarding against potential market fluctuations.

While a market downturn sound like a game-changer, it's crucial to avoid underwriting deals based on outdated metrics. Adapting to current market conditions and employing conservative underwriting practices are crucial for navigating the evolving landscape successfully. How are you leveraging market data to underwrite deals amidst changing dynamics?