SS280: Common Underwriting Mistakes That Kill Returns

SS280: Common Underwriting Mistakes That Kill Returns

Underwriting is a mix of integrating your estimates as a buyer with the seller’s actual numbers. In this episode, Charles discusses the most common underwriting traps.

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Talking Points:

  • When you are underwriting a property, you are trying to predict the next 1 – 10 years of a property’s performance. Within the underwriting, there are dozens of different line items, some of which can greatly affect your proforma’s bottom line, and since the net operating income is the determining factor in valuing a property, it is important that we spend time on the line items that matter the most. If not, we risk killing our returns.
    • 1. Overestimating Rent Growth
      • If your underwriting does not work with the property’s current income, this is a red flag. The last 12 months of the property’s income show a realistic depiction of what the property can actually achieve. If there is a pullback in the economy, most likely the rents will not decrease, but they will not likely increase either. You have to make sure that you can service the new expenses and the mortgage payment.
    • 2. Underestimating Expenses. Expenses are unlike a property’s last 12 months of income, it can vary greatly.
      • The seller might have their own management company or sweetheart deals with other vendors that are unavailable to you. They might have 20 properties on one insurance policy, which lowers their effective per-property insurance cost. The landscaper is actually a tenant of the owner at another property, and that is why they take care of the grounds for 50% of the market rate. There are so many scenarios that could explain why expenses would differ from owner to owner. This is why we need to normalize the expenses we will be paying and obtain written estimates for expenses and vendors when underwriting a property. As a side note, once you buy more properties, this scale will start working in your favor, with you having more pull with vendors and contractors. 
    • 3. Property Taxes.
      •  Property taxes are one expense that you cannot just get a quote for, and they are going to be one of your largest line-item expenses. It is extremely important to determine your new property taxes while underwriting the deal. You can speak to the local municipality and, without providing a property address, find out how they suggest you estimate the new property taxes.
    • 4. Optimistic Renovation Premiums
      • If you are planning to perform a value-add, make sure you find actual rent comparables and estimate that you will not fully achieve those comparable rents.
      • Give your business plan time to be implemented. It is unrealistic to expect to renovate a large property in 12-24 months unless you plan to have a high amount of vacancy, which will decrease your income in the short term.
      • Plan to have a slower lease-up, more concessions, and lower-than-expected rents.
    • 5. Underwriting Repair and Renovation Costs
      • Not having accurate repair estimates for correcting the deferred maintenance at a property, or not knowing the full extent of what needs to be fixed, can greatly change your underwriting numbers. If you are hiring a property management company, have them review your estimated repair and renovation costs and walk the property during the inspection. They will help you create a realistic budget for getting the property back on track. Additionally, make sure to hire specialized contractors to walk the property with you, like plumbers, roofers, and HVAC technicians. They will give you the most accurate idea of the systems’ condition and the cost to repair them.
  • When you are creating and reviewing your underwriting, spending time verifying these few line items is going to greatly increase your chances for success.
  • If you’re interested in learning more about the most important expenses when underwriting an apartment building, check out episode SS114.

Transcript:

Charles:
Most real estate deals don’t fail because of the market. They fail because of bad underwriting. A deal can look amazing in the spreadsheet until the real expenses start hitting your bank account. Welcome to Strategy Saturday, I’m Charles Carillo, and today we’re gonna talk about common underwriting mistakes that can quietly destroy your returns. Let’s get started. When you are underwriting and property, you are trying to predict the next one to 10 years of a property’s performance. Within the underwriting, there are dozens of different line items, some of which can greatly affect your performance. Bottom line, and since the net operating income is a determining factor in valuing a property is important that we spend time on the line items that matter the most. If not, we risk killing our returns. Number one, overestimating rent growth. If your underwriting does not work with a property’s current income, this is a red flag.

Charles:
The last 12 months of a property’s income show a realistic depiction of what the property can actually achieve. If there is a pullback in the economy, most likely the rents will not decrease, but they will not likely increase either, and you have to make sure that you can service the new expenses in mortgage payment. Number two, underestimating expenses. Expenses are unlike a property’s last 12 months of income. It can vary greatly. The seller might have their own management company or sweetheart deals with other vendors that are unavailable to you. They might have 20 properties on one insurance policy, which lowers their effective per property insurance cost. The landscaper is actually a tenant of the owner at another property, and that is why they take care of the grounds for 50% of the market rate. There are so many scenarios that could explain why expenses would differ from owner to owner.

Charles:
This is why we need to normalize the expenses. We will be paying and obtain written estimates for expenses and vendors when underwriting a property. As a side note, once you buy more properties, this scale will start working in your favor with you having more pull with vendors and contractors. Number three is property taxes. Property taxes are one expense that you cannot just get a quote for and they’re gonna be one of your largest line item expenses. It is extremely important to determine your new property taxes while underwriting the deal, and you can speak to the local municipality and without providing a property address, find out how they suggest you estimate the new property taxes. Number four is optimistic renovation premiums. So if you’re planning to perform a value add, make sure you find actual rent comparables and estimate that you will not fully achieve those comparable rents.

Charles:
Give your business plan time to be implemented. It is unrealistic to expect to renovate a large property in 12 to 24 months unless you plan to have a high amount of vacancy, which will decrease your income in the short term plan to have a lower lease up, more concessions in lower than expected rents. Number five, underwriting, repair, and renovation costs. Not having accurate repair estimates for correcting the deferred maintenance at the property or not. Knowing the full extent of what needs to be fixed can greatly change your underwriting numbers. If you’re hiring a property management company, have them review your estimated repair and renovation costs and walk the property during the inspection. They’ll help you create a realistic budget for getting the property back on track. Additionally, make sure to hire specialized contractors to walk the property with you. Like plumbers, roofers, HVAC technicians, they’ll give you the most accurate idea of the system’s condition and the cost to repair them. When you are creating and reviewing your underwriting spending time, verifying these few line items is going to greatly increase your chances for success. If you’re interested in learning more about the most important expenses when underwriting an apartment building, check out episode SS one 14. That’s SS one 14. I hope you enjoyed. Please remember to rate, review, subscribe, so make comments and potential show topics@globalinvestorspodcast.com. If you’re interested in actively investing in real estate, check out our mentoring programs@syndicationsuperstars.com. That is syndication superstars.com. Look forward to another episode next week. See you then.

Links Mentioned In The Episode:

  • SS114: Most Important Expenses When Underwriting an Apartment Building

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