Understanding Conservative Underwriting in Real Estate Syndication
In the realm of real estate syndication, almost all syndicators talk about ‘conservative underwriting.’ Despite its widespread use, this term can often be a source of confusion for investors. This article aims to clarify what underwriting is, the concept of conservative underwriting, and explain its significance in real estate syndication.
What is underwriting?
Underwriting is the process of analyzing a real estate investment to assess its financial risk and determine whether or not it is suitable for investment. It involves looking at factors such as the location, rent roll, tenant stability, occupancy rate, local market conditions, and more. Through this process, an investor can gain insight into the potential returns of the investment and whether or not it aligns with their goals.
What is Conservative Underwriting?
Conservative underwriting, in essence, involves adopting a cautious and realistic approach to projecting the financial performance of a real estate investment. It is a strategy that seeks to mitigate risk by making conservative assumptions about critical variables such as rent growth, expense budget, market cap rates, entry and exit cap rates, and more.
However, conservative underwriting is both a science and an art. It should not be so cautious as to stifle investment opportunities nor so aggressive as to overlook potential risks. Striking the right balance is a crucial and challenging aspect of being a deal sponsor.
The Importance of Conservative Underwriting
Underwriting involves considering the current financials of the investment along with some calculated projections of the future. Hence, being conservative in the projections being made is an essential component of a solid real estate syndication deal. It serves as a safety net for investors, minimizing the risk of unexpected downturns or unforeseen operational challenges. By providing a buffer for each assumption made, conservative underwriting enables the investment to withstand adverse conditions and still deliver solid returns to investors.
As Warren Buffet says:
“The first rule of investment is to never lose money, and the second rule is to never forget the first rule.”
Conservative underwriting is a way of ensuring that we are running the numbers in line with this philosophy. Taking a cautious approach to projecting future performance, gives investors the peace of mind that their investment is sound and will likely be protected from unforeseen risks or challenges while still providing solid returns. No one can accurately predict the future performance of any investment, but accounting for most if not all, possible risks is the key to making a sound investment decision. In real estate, money is made when we buy. So buying right with the appropriate underwriting is crucial to success as an investor.
Key Considerations in Conservative Underwriting
There are several key factors that investors should consider when evaluating the conservatism of underwriting. These include:
Market Cap Rates
Market capitalization rates or ‘cap rates’ are a critical metric in conservative underwriting. They are used to indicate the expected rate of return on a particular property. Conservative underwriting involves making reasonable assumptions about the market cap rates. It’s important for investors to scrutinize how these rates have been derived and where they are projected to be in the future.
Terminal Cap Rates
The terminal or exit cap rate is another crucial factor. It is used to estimate the resale value of a property at the end of the holding period. Conservative underwriting involves making realistic forecasts about terminal cap rates based on market volatility and the investment project timeline.
Projected Rents
Rent growth assumptions are another integral part of conservative underwriting. The underwriting should not be based on overly ambitious projections of future rent rates. Instead, it should incorporate realistic rent growth metrics that align with current market trends and conditions.
The Underwriting Process
The process of conservative underwriting involves several steps:
Obtaining the Appropriate Underwriting Model
Having the right underwriting model is essential. While there are various models available to choose from, picking one and understanding it in depth is essential to good underwriting. At the end of the day, the goal of the model is to give out numbers based on the input. So understanding how to use it is crucial without making mistakes while inputting the numbers.
Examining Current Variables for the Property
This involves reviewing the property’s T-12 (profit and loss statement for the previous 12 months), looking for trends, and benchmarking the deal. Key factors to consider include occupancy and rent prices, as well as the total operating expenses compared to total operating income.
Evaluating the Assumptions
The operator’s business plan should outline the strategies they intend to use to increase the property’s income and/or decrease its expenses. It’s important to examine these assumptions carefully and clarify any areas of concern.
Spotting Red Flags in Underwriting
There are several warning signs to look out for when evaluating underwriting. These include:
- Overly optimistic rent growth assumptions
- Significant discrepancies between the projected and actual occupancy levels
- Unrealistic operating expense ratios
- Lack of income-producing items
- Unreasonable lending rates and cap rates
Conclusion
Conservative underwriting helps mitigate risk and ensures the projected returns are achievable, even in less-than-ideal circumstances. By understanding what conservative underwriting entails and how to evaluate it, investors can make more informed decisions and select deals that align with their financial goals.
If you want to learn more about how I invest in real estate, schedule a call with me today.
Disclaimer: This article is for informational purposes only and does not constitute professional financial or investment advice. Always conduct your own research and consult with a financial advisor before making any investment decisions.
