4 Ways to Reduce Risk in Your Underwriting
I spent a lot of time over the holidays reading up on the new tax bill, soaking up articles about how it was going to affect the Real Estate industry and reading everyone’s opinions and predictions about the real estate market for 2018. It was a great time of reflection and thinking as we plot our course for 2018 (and beyond).
The consensus on the tax bill is that it will only help the real estate industry and demand for apartment living. The 2018 predictions are a little more scattered. Everyone knows we’ve had the longest positive run in the history of market cycles. And the “late innings” phrase is way overused when describing where in the cycle we are.
As a company, we’ve set a goal of acquiring 1,000 units this year. Given the market context, we’ve had many conversations about how we do that in a smart way that protects our investors’ capital and our overall portfolio. We fundamentally believe in our value-add business plan and the constant demand for updated Class B apartment housing. But to ensure we aren’t overpaying and getting caught up in the frothy market, we’re doubling down on our commitment to staying conservative in our underwriting. Everyone likes to say they underwrite conservatively, but what does that really mean? Here are the top metrics we are focused on to ensure we don’t get caught overpaying for a deal.
Rent and Expense Growth
Our markets have seen some tremendous rent growth in the last 5+ years– in some places upwards of 5% per year. Obviously that can’t, and won’t, continue forever. To stay conservative, we are expecting (and underwriting) to 2% – 2.5% annual rent growth—just below the historical average rent growth of around 3%.
In addition, we believe expenses will continue to rise. Payroll will increase every year. Contractors and services will charge more. It’s how the economy grows. But we also need to factor that in. We are using 2% annual increase in expense growth. Overall, we underwrite for rents to increase slightly faster than expenses.
Property Tax Increases
Texas has no state income tax, and as a result very high property tax rates. As such, how you treat your property tax bill has a tremendous impact on your underwriting and the viability of a project. Once we buy a property, the expectation is that the tax bill is going to jump up in line with the new value. There is always a bit of a cat and mouse game with the appraisers, but we assume the new tax bill will be 95% of our purchase price. I know some operators that use 90%, while others will use 10%-15% higher than the current tax appraisal. We opt to take the safe route and know that if we are successful in paying 90% or 92% of our purchase price, we’ve just trimmed a big expense to the benefit of our NOI.
Interest Rate Hikes
Last year interest rates rose—albeit slightly. One thing most 2018 predictions agree on is that rates will likely rise again this year. To what extent, and how the overall economy can stomach those increases, no one knows. For our part, we are underwriting to higher rates—and having strategic conversations about which debt products are most attractive right now; we’ve been looking more at fixed-rate options as a result of the rate hikes. From an underwriting perspective, we’re also factoring in higher rates than what we’re getting quoted on. This protects us from any rate movement before we close that would affect our proceeds—a practice that saved us on a deal last year and we highlighted in a recent article.
Cap Rate Expansion
Again, we’re in the late innings of a baseball game as the market is at a peak. A big concern for investors and operators are the Cap Rates, which are going lower and lower. (Read more about Cap Rates here). The cap rate affects our underwriting because we are trying to predict how much we’ll sell the property for in X number of years (for us usually 5). To predict that, we need to know the Property NOI (which we can feel pretty good about knowing) and the market cap rate. Then, you simply divide the NOI by the cap rate to get your expected sales price. The lower cap rates are, the higher your sales price. With rates currently near historical lows, we can’t expect them to continue to compress—or even stay flat. I know many operators that are using the going-in cap rate as the exit cap rate. They are betting on the fact that the market will be similar in the future to what it is today. That’s a risk we aren’t willing to take. We are underwriting to see 40-50 basis points of Cap Rate Expansion for every year we expect to hold the property. In short, we are predicting the market conditions to be worse when we sell than they are now. If we’re wrong, that only creates upside for our investors in the form of a much higher sales price.
In general, we are excited for 2018 and the opportunities we continue to see in the value-add apartment space. We spend every day looking through deals, and know that by staying conservative in our approach we are protecting ourselves when a correction does occur. Yes, it also means we lose lots of deals to groups being more aggressive in their assumptions. But in the long run, our portfolio will perform and our investors will thank us for having a truly conservative outlook on underwriting.