When you decide to invest in a real estate syndication, you’ve already earmarked your investment money and you’re looking at possible investment options. There comes a time when you want to know which deals to avoid and which ones to pursue.
Perhaps there are certain warning signals you should be aware of or some crucial information about the underwriting side that you’d want to grasp so that you can make an informed decision. That’s why you’re here today, my friend.
In this article, we’ll walk you through the data an underwriter considers in a deal, address some potential hazards, provide several example number ranges that we search for on a regular basis, and assist you understand the basic elements of the commercial real estate industry and prospective investment possibilities therein.
We’d like you to know that our team does extensive research on each investment opportunity. This is why we invest in a limited number of deals per year and will not stray from our criteria. For those few projects that do make it through our initial checks, they go through even more due diligence. In this article, you’ll get a look at the behind-the-scenes work and how seasoned real estate investors review a potential investment.
Why Underwriting is Such a Valuable Component
Imagine underwriters as the good-guy gatekeepers who, as your first line of defense against bad investments, filter out transactions that don’t match investors’ requirements.
It’s our goal to consider all the details, draw on our past expertise, and ensure that we have the opportunity to create value and purchase great bargains for our investors. Probably the most important note here is, when we’re considering a prospective investment property, we actually go there to check it out in person to ensure we feel good about the property itself and the location.
NEGATIVE ASPECTS OF A COMPETITIVE REAL ESTATE ENVIRONMENT
A deal might appear to check all the boxes at first glance – maybe it’s in a great location with a significant net increase in population, high median incomes, excellent schools, potential for rent growth, and projected good returns for investors.
The unfortunate part is that other investors want in on these deals too, and the bidding for these seemingly ideal commercial properties becomes fiercely competitive. Money pours into these deals, bidders from across the country emerge seeking investment in these types of properties.
As you know, any investment comes with inherent risks – building and renovation expenses, inflation, interest rates, and even unanticipated difficulties like plumbing issues.
What if we told you there are a few methods we use to think about all these variables so that none of us wastes time or money or time on a real estate investment that isn’t worth it?
WHEN TO PASS ON A PROPERTY: THE DETAILS
When you invest in commercial real estate, your goals are numerous. You want to make money, minimize your taxes, and have a hands-off investment while also protecting your money from loss.
To prevent losing money on a bad real estate transaction we must be able to successfully differentiate a good investment option from a poor real estate deal right away.
Whatever the property type, you’ll want one that can produce the returns and financial security you require in the time frame projected, with as little risk as feasible.
RED FLAGS FOR REAL ESTATE INVESTORS
To discover the warning signals, read between the lines any time you’re flipping through photos, touring a property, listening to a webinar, or reading an investment summary.
If you go on a property inspection and discover that the pool is closed during the dog days of summer, you may have questions. If the property manager appears unaware or unsure why the pool is shut or when it will reopen, your worries should escalate significantly.
If you notice debris in every nook and cranny, defective paneling or roofing, or unkempt landscaping, it’s reasonable to suspect property management is ignoring issues that are more difficult to detect. It would not come as a surprise on this type of property to discover dissatisfied tenants and deferred maintenance within apartments or walls that may be rotting.
Be aware of a property manager who is too quick to point out positive attributes and fails to mention any challenges or serious concerns about operating costs. If you find properties that have been on the market for a long time or are priced well under their value, proceed with caution. This often suggests that there are unknown issues.
We’d have to receive a greater return in exchange for completely remodeling, re-tenanting, and adding a new property management team if there are red flags like because it’s almost as easy to start from the ground up.
Now, it’s critical to realize that we don’t choose projects based on IRR alone. We compare the amount of effort (more work equates to more risk) we’ll have to put into bringing the property to market versus the amount of return. More work (i.e., risk) should always equal greater returns, and those returns should be data-driven.
HOW SEASONED REAL ESTATE INVESTORS LOOK AT AN OPPORTUNITY
Are you still unsure whether to accept? Let’s dig into the nitty-gritty math side of things. Take their T12 financials and make any necessary tax rate adjustments, then look at our going-in-place cap rate. We have a few years at the current, going-in cap rate since taxes won’t reassess our acquisition until year 3 for this example.
When a new tax assessment is issued, the cap rate will then have a minor downward adjustment. Meanwhile, we’re always expecting something to alter with the current expenses profile.
When we acquire property, real estate taxes, payroll, insurance, and administration costs may need to rise or fall; it’s critical to understand how cash flows will be impacted by our potential change of ownership.
To begin, calculate what your month-one income will be based on the going-in cap rate. Then compare current rents and unit mixes to those of comparable asset types in the region. You’re attempting to discover the potential value in the company plan while pulling comps.
In other words, will the rent rate reflected by similar commercial real estate in the area be high enough to cover the cost of needed renovations on this property while still providing cash flow?
Look for comparable units, built around the same year as yours, that have already been renovated and use their current rates to calculate your anticipated commercial property lease rates.
THE UNDERWRITER’S SAMPLE NUMBERS
Let’s assume that after renovations are completed, we can charge an extra $337 per month per unit. Roofing, siding, kitchen and bathroom improvements, pool repairs, and replacement of all polybutylene piping cost $17,000 each unit. Increasing rent by $337 per month results in an extra $4,000 in monthly income. We divide $4,000 by $17,000 to get a 22.5% return on investment. When we look at returns on investments of 18%, 20%, and 22 or more, we see that we’re getting enough revenue to justify the renovations.
EVALUATING FINANCING OPTIONS
Finally, we must explore our financing options. We consider the cap rate, the potential rent increase, and the property’s existing cash flow (think month-one numbers) when deciding which financing option(s) to pursue. In this interest rate environment, we are pursuing property purchases using fixed interest rate debt or potentially using floating rate loans with an interest rate cap (ie ceiling) depending on the price. Additionally, when pursuing fixed rate debt, we ensure prepayment penalties won’t jeopardize projections if we are able to execute our business plan in less than the projected timeframe and sell the property early.
EXPLORING PROFITS AT SALE
After we’ve got our costs, financing, and some other fundamental figures, we need to figure out what the property may sell for in approximately 3 to 5 years after renovations are finished and tenants are paying market rates.
Let’s assume that, for the sake of this example property, renovations are complete by year three and that the property is stabilized. Our starting net operating income (NOI) was around $1.1 million, with a year-three NOI of about $1.6 million, demonstrating that we’ve essentially created $500,000 in additional income.
This is when we check what the brokers are saying. We end up with only a 10 percent IRR for limited partner investors after plugging in how much the brokers think the property will sell for, purchase price, renovation expenses, and increased rent.
ALL THINGS CONSIDERED, ARE THE RETURNS WORTH IT?
On this occasion & with these types of projected returns, we’d opt to pass on investing in this property. When we consider the alternatives for commercial real estate investments that are less risky and offer greater returns than this one, the profits aren’t enticing enough to us or our investors.
There are no clear standards for what constitutes “excellent” returns, and the market, economy, tenant choices, management expenses, taxes – just about everything – is in a constant state of change. For the last 10 years, cap rates have been on the decline. The figures we give you today, may not be valid in five years from now so we are constantly reevaluating the market and our offerings.
Overall, each commercial property’s prospective investment success should be examined in terms of risk-adjusted return. You should always be comparing returns against the amount of risk your money faces when you consider the deal’s class, location, and business plan. The higher the returns, the more risk the opportunity may have, which is why you should understand the evaluation process a sponsor team goes through.
Why PREFERRED RETURN STRUCTURED DEALS ARE IN YOUR FAVOR AS A REAL ESTATE INVESTOR
What if (and would it be advantageous for) a sponsor to just ignore an issue to alter the figures into something more appealing so investors will buy in? In a nutshell, no one involved would benefit from this!
In a preferred return arrangement, limited partner investors receive all returns up to a certain percentage until the commercial property generates more than that. As a result, the sponsor team is strongly motivated to ensure that the profits exceed the preferred return rate.
No one wants to work for nothing, which is why all elements are thoroughly investigated ahead of time, including supply and demand, property management, and the sponsor team’s track record.
THE BOTTOM LINE
Now you know all about the initial phases of real estate investing that provide us a simple yes or no to determine whether we should continue delving into the details.
If the property needs major renovations and we’re expecting a 10-11% IRR, it’s not worth it to us or our investors, so we move on to look at the next prospective investment. On the other hand, if we find newer construction with little-to-no renovation requirements that returns a 15-17% IRR, there’s a good reason for us to continue our research.
In other words, by the time a possible real estate investment opportunity reaches your email, the One Street Capital team has completed many levels of due diligence, as well as a sensitivity analysis and more number-crunching. If you’d like to learn more about our deal flow, we’d be delighted to welcome you as a member of the One Street Capital Investor Community and schedule a meeting with us so we can learn more about your investment objectives and assist you in reaching them!