Hi, this is Devin Elder. In this video, I wanted to talk about three concepts related to multifamily underwriting. Underwriting is simply the process of looking at all the numbers on a project or an apartment investment and seeing if it makes sense to go out and purchase and raise money for and go operate the property for two, three, four, five years or longer as an investment.
I want to focus on three components here. Multifamily underwriting is a complex undertaking, but there are three components here I want to touch on and this might help you if we’re evaluating an investment or you’re underwriting investment yourself maybe for the first time. The first thing I want to talk about is rent growth here. We’re going to bake in some assumptions on our underwriting that we’re going to assume that there’s going to be some rent increases year over year. Let’s say we look at a five year hold on a project. We’re going to go ahead and assume that rents are going to go up 2 to 3% per year.
Now, this is mid 2018 when I’m recording this video. We are in an unprecedented long stretch of low interest rates that we’ve never seen before in world history. Nobody’s got a crystal ball but potentially we’re long overdue for a correction. You might model rent growth of 2 or 3% year over year. But you’re also going to want to do a sensitivity analysis to show what happens if you have rent decline and what does that do to returns and what your breakeven occupancy and those kind of things. But you’re not going to want to model moving forward a 4 or 5% rent growth. Just because you’ve seen that in the past years doesn’t mean that can continue moving forward. This is just part of conservative underwriting is your rent growth model. We model 2 or 3% rent growth and we also model 2 or 3% expense increase in general except for taxes.
We’re in Texas and taxes are the only complaint I have about being an investor in real estate in Texas. Texas is a fantastic market. I love it. I’m in San Antonio. I love this market. But taxes, we are getting hammered right now. We’re seeing increases year over year of substantial tax assist values going up.
We model substantially more for tax increase, especially after taking over a property because we know that tax bill is coming, so we want to model for that. But the other expenses like payroll, things like repair and maintenance or some of our other expense line items, we might see a 2 or 3% increase year over year.
The next component of multifamily underwriting that I wanted to discuss is this exit cap rate. Cap rates have been compressed over recent years and it stands to reason they may expand, especially as we’re going into a rising interest rate environment here. Nothing radical. There are folks that I talked to that have been in this game for many more decades than I have that say that a single digit interest rate is a good interest rate so that puts things in perspective as we start to creep over 5% for interest rates on multifamily loans here in 2018. In the scheme of things, it’s still a very good rate.
What we want to do on our exit cap rate … Let’s say we’re buying a property at a six cap. We might sell it at a six cap in five years and make a very good return off that, but we don’t want to model selling at a six cap. We want to model that cap rate going up in the future if interest rates rise and cap rates expand because again they’re very compressed right now, and it stands to reason that they may not stay that way forever into the future.
Typically, as part of an underwriting model, you might see expanding over five year period, you might see expanding 10 basis points a year. If you’re at a six cap, you might have … At the purchase, you might have an exit cap of 6.5 at exit. 10 basis points a year to get to a higher exit cap rate. If you’ve got room in your underwriting model or really you want to underwrite as high of an exit cap rate as you possibly can, if you can get it a full point or a hundred basis points over what you bought it at, that’s just going to be cushion for you, for your investors and so we try to model as high of an exit cap rate as we possibly can and that just creates cushion. We want to be conservative in every component of the underwriting here. Seeing an exit cap rate that’s higher than the purchase cap rate is always a good thing.
The last thing here is a capex. This is just the capital improvements to the property. There might be deferred maintenance on the property. You might have to go in and spend a million bucks on HVAC, new parking lot. Maybe there’s electrical repairs. Maybe there’s roof damage. Obviously in a multifamily project, let’s say about a hundred or 200 unit property, you can get into the millions of dollars on your capex so you’re going to go through on your due diligence with your contractor or your team of inspectors or whatever the case is. You’ve got a team on that front end right after you put a property and a contract to go in and really crawl through the whole property, walk every unit and put together a capital improvement budget for that property that you might execute over 12 or 18 months.
Then what you’re going to want to do is tag on probably another 10% or 20% if you can fit it in there because, especially if you’re buying a ’70s property or, geez, even a ’60s property, there’s just going to be surprises on the property. Just like flipping a house, you get in there, start opening up walls, there’s going to be surprises. You need to have a contingency on your capex budget.
I feel like 10% is reasonable. More if you can fit it in there and the goal is just to be overcapitalize on a project going in so that you never have to have a cash call with your investors. Nobody ever wants to hear their project ran out of money. You want to be overcapitalizing your capex budget going in and that will ensure that you just have that money in the bank there to go ahead and complete all those repairs. Now, if you can work with your vendors or you can source materials cheaper, you can drive those costs down, that’s great and that only improve the performance of the investment, but you certainly don’t want to skimp on your capex or undershoot it.
Those are three components of multifamily underwriting that I want to touch on and something that you might evaluate. Let’s say you’re evaluating investment in a multifamily syndication, you’re going to want to look for these things. What are the rent growth projections? Are they projecting 4 and 5% rent growth in the future? It might be unrealistic. Is the exit cap rate higher than the purchase cap rate? Because we have to account for the possibility of interest rates going up and cap rates going up. Then is your capital improvement budget has some kind of contingency in it for overages and things like that?
Clearly, there is more to multifamily underwriting than these three components that I mentioned here, but these are three important ones that I wanted to just highlight in this video and hopefully that helps you understand the multifamily underwriting process a little bit better. Thanks. Have a great day.