Don't Do This in a Competitive Market
Be disciplined in your underwriting and don't get hurt, while others take on additional risk.
In today’s tight multifamily market, investors are frequently faced with what to do in order to be competitive while submitting offers on properties. With prices growing and cap rate compression taking place, it’s harder for investors to hit benchmark numbers that they are used to hitting. This leads some to increase the prices they are willing to pay and slim down their margins just in order to win deals. There are many problems with doing this however.
One common way that investors will cut corners on their underwriting is in estimating their vacancy factor. Let’s say the market is currently averaging a 96% occupancy level and because of this, the investor uses a 4% vacancy contingency when underwriting the property. This might work out okay in the short term while the market still has a very strong rental demand, but what happens when the market slows and occupancy levels drop to 92%? That same investor is now in trouble because they were too aggressive on the front end and underestimated the true vacancy cost. Now they will have to try and cut corners elsewhere to make up for this mistake.
A second way of making poor estimations while underwriting is assuming that rents will continuously rise at the current pace. Let’s say for example rents are growing at a 4% rate per year. Instead of underwriting to what the current rents are, some investors will look at what rents will be in 2-3 years and base their projections off of that. This will “allow” them to pay more for the property, thus enabling them to be more competitive. Clearly this also is dangerous because if rents stop growing at the 4% rate, this investor is in trouble once again.
Lastly, and probably the most important factor, is greed and impatience. When the numbers simply won’t work and an investor goes ahead with the deal anyway just for the sake of doing it, it usually doesn’t end well. Some people get in the mindset of, “I can make this work because of x, y, and z…” and they think they are invincible. When the market shifts, these are the same people who end up losing properties back to the bank because they paid too much on the front end and could never recover. Greed is a huge driving factor in the inflation and collapse of markets, whether it be real estate or equities. Feeling like you can make everything work is the beginning of the end for many great careers.
It is difficult when you are working in a market that is very competitive where some prices just don’t make sense. One thing to consider, it is much better to not do a deal than to do a bad deal. Especially when you are raising capital from investors, getting into a bad deal because of poor underwriting is a bad mistake.
What are your thoughts on working within a very competitive market?