Sound underwriting can reduce investment risk and help identify opportunities that will drive investment performance.
The global pandemic has introduced many uncertainties in life and real estate markets. Multifamily real estate, specifically income-generating property, has generally been a stable and high-return asset class. During the Great Recession, for example, multifamily properties offered an optimal housing solution as many people couldn’t qualify for mortgages and the asset class also presented a good financial opportunity for investors and lenders alike. Investment in the asset class soared to $154 billion in 2017 from $104.6 billion in 2007, according to Real Capital Analytics.
Because demand can quickly shift, multifamily real estate investors should have a deep understanding of what strategies helped investors emerge on top during other crises. Obtaining the right financing is critical, but performing thorough analysis of the asset and identifying other components such as city growth and market tax implications are essential to weathering any storm.
It all begins with strong underwriting practices. The real estate industry is teeming with properties that look promising on the surface but have many hidden issues. This is why it is essential to conduct a thorough and rigorous underwriting process. Sound underwriting can reduce investment risk and help identify opportunities that will drive investment performance. More importantly, it can help insulate an investment from downside risk when a significant crisis occurs.
What is Real Estate Underwriting?
Real estate underwriting is the process by which real estate assets are evaluated to determine their potential. When done right, property underwriting is a complex and rigorous process. It involves analyzing the consequences of hundreds of variables – from the assumed purchase price of a property relative to its competitive set to installing a keyless entry system.
The saying “the devil is in the details” rings true when investing in multifamily assets. All the details that are derived from the financial analysis can either make or break the desired return. Rigorous underwriting practices not only help ensure consistency and efficiency when evaluating individual property investments but also increases an investor’s ability to select investment properties that are most likely to meet or exceed return expectations. In the following paragraphs, we will explore four ways strong underwriting can help insulate real estate investments during a downturn.
1 | Evaluating the Physical and Economic Occupancy
Vacancy is the dreaded word in multifamily investing. As a real estate investor, the focus is on minimizing vacancy and achieving full or nearly full occupancy to produce maximum income generating returns. In multifamily real estate there are two types of occupancy: physical and economic. Physical occupancy, the more familiar type, refers to the number of units with a tenant with a signed lease. Economic occupancy is equally as important and refers to how many occupied units are actually paying rent.
When evaluating a multifamily asset, it is critical to assess both the physical and economic occupancy to determine how an asset is operating. A property that shows market rate physical occupancy but below market economic occupancy can signal there is something wrong with the asset, such as:
- Sub-standard tenant evaluation policies
- Habitually late paying tenants
- Poor rent collection practices
Physical occupancy is an important metric, but economic occupancy is what determines how well a property will perform. It is essential to have a firm understanding of both and evaluate how the asset will perform during an economic downturn before an investment is made.
2 | Debt and Financing
During market uncertainty, lenders often quickly amend lending programs, rates and other terms, leaving many investors grappling for favorable alternative financing options. Cultivating relationships with banks and local brokers is critical to an investor’s success. These relationships can provide insight into market trends and other factors that can impact an investment.
It is prudent to speak with several banks and lenders in the underwriting stage to identify the optimal financing structure and understand market trends. The amount of leverage you can attain on a particular asset, for example, is a crucial component of most multifamily real estate transactions. Common financing terms of multifamily loans include yield maintenance and prepayments. Being informed about how these features work and how they can impact an investment is important as often there are steep penalties associated with both. These terms can also inhibit an investor from quickly selling an asset, so a complete understanding of the terms is essential before signing any agreement.
Equally, having a comprehensive understanding of the financing mechanics is good practice. For example, if building occupancy falls below a certain metric, what prepayment or finance terms are triggered in the loan agreement? Becoming familiar with the options and the financing mechanics will help you plan for the inevitable “what ifs.”
3 | Capital Expenditures
During the due diligence phase, it is critical to assess what improvements need to be made to an asset to compete with comparable properties. Walking the property is an excellent first step to quickly identify any weaknesses or issues that need to be immediately addressed, like outdated countertops or the need for new tile in the building foyer. Taking the time also to walk neighboring properties is prudent and allows investors to assess amenities or enhancements that will garner higher rents and attract quality tenants.
Bringing in a trusted contractor to walk through the property and review the list of capital improvements is recommended as they have the knowledge to properly assess the cost for the project at hand. The labor component is a critical piece of any multifamily property investment and can significantly affect the bottom line. By performing thorough due diligence, investors will mitigate any unforeseen issues and also help secure better financing options. Both are critical during any market environment but are especially vital during times of economic uncertainty.
4 | Understanding Market Tax Implications
Every city has felt the tax pinch from budget shortfalls during this most recent crisis. Understanding the timeline of projected future assessments and how cities will respond is important when considering investing in real estate. Staying apprised of local sentiment and political issues will help gauge the likelihood of major tax changes in the near future. Unforeseen and planned increases directly affect an investment’s bottom line and projected returns on investment. So, stay in front of them by forging strong relationships with local operators.
Strong underwriting practices is not a nice-to-have but a must-have for private equity real estate investment firms. It can reduce investment risk and also identify opportunities that will drive investment performance.
At Lucern Capital Partners, capital preservation is our top priority. We want first to ensure investors’ capital is protected and then identify the key drivers that will generate strong risk-adjusted returns. To accomplish this, we take a prudent approach to underwriting by accounting for potential crises that could negatively impact short-term cash flow and long-term returns on our investments.
Learn more about Lucern Capital Partners’ investment approach by reaching out to a member of our team.