Introduction
Underwriting, whether for investments, loans, or insurance, relies on accurate risk assessment and forecasting of the financial value of a real estate asset. Mistakes here can be costly, both financially as well as reputationally.
Luckily, there is a way you can avoid them.
I’m Anton from IntellCRE, and in this video, we’ll go over eight of the most common underwriting mistakes that we see our clients make and the safety measures you can use to avoid them.
Mistake #1: Unrealistic Rent Growth Assumptions
Let’s begin with mistake number one.
This is assuming that we can raise rents quickly without considering the market’s actual supply, demand, tenant income levels, as well as the realistic timeline for the rent increase to take place at our property.
Just because your rents are significantly below the market doesn’t mean that your property can operate at market levels tomorrow.
Make sure you research the trends affecting your market, noting any rent control laws, and work with conservative assumptions for your rent growth.
The timeline on how you’re going to grow your current rents to the proforma values should be realistic. In other words, the stabilization period must be realistic.
Do we need to do any capex or renovation projects at our property in order to achieve the market rent? How long would these projects take, and how soon after these projects are finished can we find new tenants for our property?
All these things must be carefully considered and accounted for with longer timelines in your underwriting for rent stabilization and with lower proforma rent growth rates.
Mistake #2: Underestimating Expenses and Deferred Maintenance
The next big mistake is underestimating expenses and ignoring deferred maintenance at the property.
This includes forgetting about repairs, turnover costs, property management fees, and especially capital expenditures like changing the roof, HVAC, plumbing, or electrical replacements.
Only once you walk the property and have a general inspection done do you really know the scope of work that the property requires.
If the electrical panels are old, you’ll have to replace them to avoid liability issues, and this could be a significant project both time-wise and cost-wise.
Similar projects like unit rehabs will definitely increase your vacancy and cause significant rent loss.
Property management fees are generally around 5% of your gross operating income. For properties with a higher number of units, you’ll probably need an on-site manager or janitor, which can result in at least $24,000 of annual expense.
Make sure you understand the state of the property and the scope of the work required to bring it to the desired standard, and include the associated costs and timelines for these projects into your underwriting projections.
Mistake #3: Ignoring Realistic Vacancy Rates
Let’s look at the third mistake, ignoring realistic vacancy rates.
Have you ever used a perfect 0% or 2% vacancy to model your property when the market average is around five, six, seven, or eight percent?
Especially for small multifamily properties, having one or two units vacant for a prolonged time is going to result in significant vacancy and income loss.
Always make sure that you research real vacancy rates in your market and work with conservative, pessimistic assumptions in your model to avoid miscalculating realistic returns of the property.
Mistake #4: Not Stress Testing Financing and Interest Rates
The next mistake concerns your deal financing, and in particular not stress testing your financing and interest rates.
Locking in rosy financing assumptions without modeling what happens if rates rise before closing or refinancing is where this mistake happens.
Make sure you know where your financing terms are in your market, and stress test your underwriting with multiple scenarios with higher interest rates.
When your property has a higher current vacancy, many lenders will use your current rent with that high vacancy figure to calculate your DSCR and quote you with a much lower loan-to-value than you might expect.
The safest approach is to work with realistic current rent figures and stress test your underwriting for financing rates and other financing terms.
If you’re planning to use an interest-only loan where you don’t pay principal payments in the first months or years, make sure you also look at your deal as a fully amortized loan where you’re paying both principal and interest, and ensure that a DSCR of 1.25 or higher is met.
Mistake #5: Using Seller or Broker Numbers Without Verification
Let’s go to the next mistake.
Using sellers’ or brokers’ numbers without verification.
This means relying on trailing 12-month statements or the offering memorandum without checking utility bills, tax records, and actual rent rolls.
The selling side often wants to make the deal seem better than it is, and brokers use unrealistically strong performance assumptions to present their deals.
It’s very important to challenge their numbers in your own underwriting by researching your own rent, sales, and expense comparables, as well as operating benchmarks for the market, property type, and property class.
Mistake #6: Forgetting About Property Tax Resets
Another big mistake is forgetting about property taxes resetting.
In many markets, property taxes jump significantly after the sale, and missing this can wipe out projected cash flow, sometimes entirely.
Make sure you understand not only what the base property taxes were last year, but more importantly what property taxes you can expect in the coming years.
If the property gets reassessed after the sale, understand the millage rates, effective tax rates, and their growth rates moving forward.
Mistake #7: Overlooking Market Cycle Risks
The next mistake is harder to spot but can significantly change deal returns.
Overlooking market cycle risks means projecting stable or rising occupancy rates and rents when job losses, construction booms, or regulatory changes could impact demand.
To avoid this, look at past cycles in local, national, and global markets and account for how market downturns can affect your forecast.
Another option is consulting with a market expert and incorporating this risk into your analysis and stress testing.
Mistake #8: Skipping Exit Strategy Math
Finally, especially when underwriting investments, you can never be too cautious with your exit strategy.
The last mistake is skipping your exit strategy math.
This includes not running numbers on selling earlier, refinancing later, or holding through a market downturn.
Track how your net operating income can grow realistically and what exit cap rate you can expect in each year of your hold period.
Make sure that even if you exit earlier than planned, the returns still make sense.
It is absolutely necessary to stress test and run sensitivity analysis for key assumptions, especially exit cap rates, as they have the biggest impact on returns.
Don’t forget to stress test refinance cap rates as well.
And in the previous mistake, we discussed market downturn a bit. Though nobody has a crystal ball and as with any other type of investment, no real estate investment comes without a certain level of risk.
Summary and Final Thoughts
We discussed eight of the most common mistakes clients make when underwriting deals.
When underwriting your next deal, make sure you understand where the market is heading and the assumptions you’re making around income growth, taxes, expenses, interest rates, and exit strategy.
Confirm multiple sources, use conservative numbers, and most importantly, stress test your underwriting through sensitivity analysis.
Do not turn a blind eye to the bad side of the deal. If the downside is still acceptable, you may have something worth pursuing further.
Thank you for watching, and hope to see you in the next video.
