Signs A Deal Is Underwritten Too Aggressively
Aggressive underwriting can lead to missed projections or even loss of capital, so I want to make sure a deal has solid underwriting from an experienced team. Here are the top 2 things I look at right away that can help me decide if a deal is underwritten too aggressively:
Quick Notes:
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Organic Rent Growth: Organic rent growth nationally tends to average 3% per year. In some markets the rent growth has been significantly more aggressive, but many operators feel comfortable with 3% rent growth in most markets.
However, because some markets have been crushing their rent growth assumptions, some operators have gotten too aggressive in their projected organic growth. This is significant because these projections build off each other, meaning if you miss your projections one year, it’s likely you’ll miss the next year, and if this compounds over multiple years your exit projections can end up significantly off.
Example: If you have average rents of $500 and you project year 1 growth at 10% then year 2 growth at 5%, that means you’d go from $500 to $550 then to $577. But, if year 1 growth is closer to 3%, even if your year 2 is accurate, you still miss your projections by quite a bit. You’d go from $500 to $515 then to $540.
A $37 per unit difference in value spread across possibly hundreds of units could create a significant decrease in value.
For 100 units at a 6% CAP rate, that’s $740,000 of value wiped out because of 1 year of aggressive assumptions.
Note: Organic rent growth does not mean forced appreciation or growth from renovations.
Exit CAP Rate: The CAP rate has one of the largest projections of value in the underwriting, so getting too aggressive on it can mean a big miss in projections for passive investors.
Most investors will underwrite an increase in CAP rate, generally 1 basis point per year. So with a 5-year deal we’d generally see the CAP rate increase by 0.5%. This has been common practice for a while, but what passive investors should realize is these CAP rate projections should be made on the market rate, not the purchase rate.
Many properties are not bought at the market CAP rate, especially value-add properties where the CAP rate will be very compressed. It’s important for passive investors to understand the market cap rate for the market the property is in and to judge exit cap rates based on the market, not on the cap rate the operators are purchasing at.
Summary
Organic rent growth and exit cap rates are 2 of the largest factors that can swing underwriting. Passive investors should understand how aggressive they are comfortable with organic rent growth (not growth from renovations or forced appreciation) and where the current market cap rate is for a property, not the purchased cap rate. Understanding and keeping these 2 items in check will shield most passive investors from investing in deals that are too aggressively underwritten.
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