Raising Capital With New Rules For Underwriting Real Estate Syndications

Raising 1 million dollars or more for your next real estate deal starts with a proper underwriting of the deal and all the inputs that go into underwriting. This is the foundation for a successful capital raise, as well as a successful deal that provides greater returns to your investors and builds a solid track record for your business.

But, shouldn’t you just be able to borrow someone else’s underwriting model, plug in the pro forma numbers, and easily see if a deal is good? Unfortunately, it’s not that easy.

Fundraisers in real estate know that underwriting takes more than just excellent spreadsheet skills. In fact, it may be more of an art than traditional real estate investors realize.

Underwriting real estate assets to be able to exceed projected returns involves a deep understanding of financing, risk assessment, market conditions, and broader economic trends. From the micro to the macro, a real estate underwriter must have a thorough understanding of various subjects to confidently project returns and deliver upon those projections to raise more money for subsequent deals.

Raising Money For Real Estate Begins With Excellent Underwriting

Basically, successfully raising capital in real estate requires delivering on the projected returns. This begins with proper underwriting.

While many elements of the underwriting process remain the same no matter where we are in the economic cycle, additional attention should be paid to specific areas within the underwriting process during a downturn. Due diligence should expand in certain areas to evaluate any investment opportunity when the economy is in a rough patch.

In this article, we’re going to cover three tips to consider when underwriting deals to raise funds during a market downturn. These are not creative ideas to improve returns or tweak numbers. These are essential considerations any company should employ to be able to deliver returns to their investors.

Related Video: The Secret To Raising More Capital For Your Syndication Deals

Due Diligence For Market Conditions and Raising Funds

Market conditions surrounding a potential property can greatly impact the success of raising money, the implementation of the business plan, and the satisfaction of your investor group with the investment opportunities you’re providing. Remember, it always comes back to creating excellent returns for your investors and building up your track record.

Many of the past year’s sought-after markets may be getting overheated, or overrated. Predicting when market growth will slow is just that – predicting. However, several factors can provide clues that markets may not see the type of incredible growth they have become known for during a rising market.

Underwriters can look at the pipeline for big development projects in the local neighborhood, the greater MSA (Metropolitan Statistical Area), and the larger metro area. If double-digit rent increases had been occurring, it may have been due to a lack of supply. If the number of units is about to greatly increase, that supply may more easily be met.

Therefore, rent growth in a market with increased development projects should likely be modeled with lower numbers.

Operators may be excited to jump into markets that are hot, thinking that they’ll be able to raise money easily for deals in these locations. However, raising money should be more about delivering on (and exceeding) your projections for your investors – not hitting some capital number raised or number of units in your portfolio. Investors will appreciate a team showing that a “hot” market may be cooling off, rather than jumping on a bandwagon.

Raise Money From The Banks With Caution

Financing placed on a deal can greatly impact projected returns. Interest rates may put back or take away millions of dollars from reserve accounts — dollars that could be returned to your investor group and the general partnership.

The Conservative Approach and Fixed Interest Rates

When interest rates are volatile, most conservative operator teams will only take on fixed-rate debt. This type of debt and the subsequent cost to the business can easily be predicted throughout the life of the investment if the rate is fixed for the duration of the asset hold period. That cost will not increase.

Your investors may desire this kind of certainty in their investing. Or, they may be willing to take on the risk of a potentially rising interest rate (and the increased cost to the business that will require). Ultimately, knowing your investor’s risk threshold will help you underwrite deals that will be more attractive to your investors (which will help you raise money easier).

The Risk Of Floating Interest Rates

Floating rates can introduce significant problems for cash flow to a business. If rates increase, funds from income are used to pay the banks rather than distribute to investors. If rates continue to rise, and income can’t cover the increasing expense, an operator may need to pause distributions. If the situation doesn’t improve, they may need to take the dreaded step of doing a capital call. Capital calls are not helpful when you’re trying to raise funds for your next deal. The news gets around. From there, if funds from a capital call aren’t available or aren’t sufficient, a foreclosure may be possible and investors could lose all their money.

There are some benefits of floating rate loans because they can be good for certain investments. Mezzanine or bridge debt can be useful for a short-term borrower who needs cash to implement a business plan in a short amount of time. For example, a construction loan or a renovation plan to improve a property could make use of a short-term floating rate loan in order to complete the loan. Many times fixed rate deals will require a longer term and might not make sense for a group with a capital-intensive business plan.

Underwriters should study economic cycles, and have a strong understanding of the market dynamics that can lead to the Fed rising interest rates. For instance, a good underwriter may see that the government has been pumping money into the economy, which may eventually cause inflation. To cool that inflation, the Fed may rise interest rates.

Interest rates are very speculative and a good underwriter is trying to mitigate risks as opposed to perfectly time the interest rate movements. They are knowledgeable of the current economic decision, have talked to a variety of debt brokers, and has done an analysis on the forward SOFR curve and stressed the various debt options available.

To Purchase A Cap or To Not Purchase A Cap, That Is The Question

In this situation, the syndication team may opt to purchase an interest rate cap to limit the potential growth of their rates. These caps may sound like an easy solution, perhaps something operators should always purchase, just in case.

These caps also cost hundreds of thousands of dollars. Or more.

That’s a big impact on the amount of money required to raise, the total cost of a deal, and the ultimate projected returns for your investor group.

Some investors see the purchase of a cap as an unnecessary burden to the investment, since it may decrease projected returns. However, if that cost is incorporated into the deal and the projected returns still fall within your range, that risk may save investors more capital.

Ultimately, the way a deal is financed comes down to how the numbers fit into the entire underwriting picture. Real estate syndication deals must be properly underwritten first before the leverage element is incorporated. The financing must fit into the deal – not the other way around. Underwriters should never move numbers around to get a financing package to work, especially if that leverage is not something you and your investor group are comfortable accepting.

Financing, Due Diligence, and Raise Impacts Summary

Fitting in the debt piece that will work for your deal and your group can be summed up in these 4 steps. Remembering hiring a third party to provide another underwriting opinion can be extremely valuable, particular for inexperienced underwriters.

Step 1: Underwrite conservatively.

Always underwrite using data first, before you decide on an offer price or debt package. Not the other way around.

Step 2: Determine your debt structure.

How much debt are you and your investor group comfortable putting on the property? This is more than an internal decision. Gauge your list by asking investors during your calls how they feel about debt in this market. If you believe a specific debt package is the best, but your investors aren’t comfortable with it, you’ll never inspire them to invest.

Step 3: What is the purchase price you are willing to pay and how much debt does that require?

Next, determine what you ultimately want to pay for the property and how much capital will be required to fund that price. Do you have this raise capacity now? Then, begin to look at what debt could fit into that purchase price.

Step 4: Iterate.

Tweak the purchase price and the debt structure until it aligns with your goals.

Related Video: Top 5 Reasons To Become A Capital Raiser

Estimating Rent Growth and Occupancy In A Business Model

The idea of rent growth can be a sensitive subject for retail investors to get behind. Rent sensitivity can be perceived as high when the market takes a downturn. It could be possible to imagine that rents can’t increase, that renters simply can’t pay more money, or that rents won’t sustain the kind of growth from the previous bull market.

There are truths behind many of these beliefs. As we mentioned earlier, a solid understanding of local market dynamics will help an operator team gauge whether they are entering a newly popular and rising market, or one that is starting to cool off (i.e. start seeing a decrease in growth rate).

As an underwriter, you have to trust that your rent growth numbers are based on real market data with comparisons (e.g. comps) from nearby properties.

How To Use Comps To Project Rent and Occupancy

Anytime a syndicator, or sponsor, doesn’t have concrete comps to support where their business plan projections come from, that is a red flag for investors. In value-add deals, an ideal comp is an already renovated property in the same MSA. In development deals that aren’t pushing rent, comps can be based on newer class A products nearby.

Ultimately, assumptions must be made when growth projections are incorporated into underwriting analysis. No one knows exactly how much we’re going to get in the next few years. We can identify trends, but during a downturn, rent growth won’t be what it looked like in the last few years of a rising market. Document assumptions and use data to support them.

The conservative underwriting approach would be to not underwrite the increases we saw during and post-pandemic years. This event disrupted the markets in a unique way, and shouldn’t be used as a baseline. Instead, look at 3rd party reports and the development pipeline. Additionally, dive into historical data from before 2019, and review those data against current trends and reports. 

Occupancy Impacts During A Downturn

The number of vacant units can drastically impact the money collected and distributed to owners of a multifamily property. Property managers’ efficacy can be tracked using occupancy as a key performance metric, or how many of the units are occupied.

Understanding occupancy numbers in the previous months of operation is the first place to start. It could be easy to take a desired occupancy rate, such as 95%, and plug it into your analysis for future occupancy predictions without digging into the data.

While it may seem positive, you should be asking why the occupancy was so high. Were the previous owners giving extra discounts to fill units and get more money in the books before selling the property? Was there a local event that temporarily impacted occupancies, such as damage to the building or renovations?

Lower occupancy numbers could indicate a value-add opportunity to increase the appeal of the property. It could also provide clues to the property manager’s ability to fill units.

With either high or low occupancy, taking a step back and observing population and job growth, as well as migration patterns for the area can help to put a slower economy into context as well.

In the end, rent growth numbers and occupancy predictions are all projections. But when based on data, we make better assumptions. Better assumptions can reduce risk and help your team to raise more money.

Using Concessions and Other Management Incentives In A Business Plan

To fill vacant units quickly, many property managers use rental concessions, or discounts offered to potential tenants to entice them to sign a lease. These could be an initial rent-free period, reduced rent or fees, or lower security deposits, for example.

If rental growth has slowed, there may be a need for more concessions to fill units quickly. However, each discount or unpaid month of rent impacts the total net operating income (NOI) of a property. Your raise capacity may be impacted if your NOI decreases since your return projects will also change.

Estimating concessions should be based on nearby data, similar to rental growth projections. What are other similar properties offering in the same area? It may be necessary to call other rental offices to ask about offers they have for signing a lease, even posing as a potential renter.

Every deal is unique, but it is common to see underwriters incorporate at least a 1-month concession into their analysis of a deal. There is no standard here.

Property managers have also found other creative ideas to entice new renters to sign leases. Many are opening offices or clubhouses on the weekends. Marketing can always be improved. And policies around subletting and increasing flexibility for tenants to list their units as short-term rentals have also worked to creatively fill vacancies.

Should You Lower Capital Expenditures?

Spending money during a downturn doesn’t feel great. We often feel the pull to hold back, or save more for the “just in case” scenario. This sentiment could prevent a team from planning any major value-add components in a business plan.

Underwriters may reduce the capital expenditures required to match the sentiment that renovations may not be appropriate during a downturn. Hearing that investors are starved for cash flow, they may also attempt to keep spending lower so that investors receive larger distributions right away.

However, reducing the raise amount by lowering capital expenditures could also expose a property or business to additional risk, as well as lead to a loss in potential profits for the business from the proceeds of a sale.

Raising adequate funds for a reserve account is the conservative approach to developing a solid business plan and underwriting during a downturn. Even if this requires your team to raise money, possibly millions more, to cover this line item. It could also allow you to weather any further economic storm to come.

Having adequate reserves may allow you to exceed your return projections if other teams in the area were unable to make necessary value-add improvements as presented in their business plans. Your property may be more in demand in a 5-year hold period.

Always include an adequate reserve fund and capital expenditure fund in your underwriting. If your business plan includes any value-add component, you’ll want to ensure those funds are available immediately — not when cashflow allows. If necessary, these numbers can be modified later.

Know What You (And Your Investors) Are Comfortable With To Raise Money Easier

Ultimately, a conservative underwriter should double. This includes but is not limited to, financing structures, rent growth projections, and concessions. These numbers need to be repeatedly stressed or moved around to see how sensitive they are to changes.

Another option is to hire a third-party underwriter to provide another expert opinion and stress-test a deal even further. This is an extremely wise option (one that could save millions of dollars down the road), particularly for newer underwriters who may not know how to thoroughly stress test a deal.

Since underwriting is so heavily based on projections and assumptions, having an understanding of the impact of small changes (gained from the stress analysis) will go a long way in communicating deal details to your investors and help you raise money more easily. It will also give you more peace of mind and create a more resilient business plan.

You can also gain incredibly valuable insight from your investors. They likely don’t have your expertise and skills in putting a deal together (that’s why they look to you for an investment opportunity), but they do have risk tolerances that impact your business and ability to raise money.

Perceived Preferences To Invest

For example, if you believe buying a cap on a floating rate will excite your investors because of the decreased risk to raising interest rates, but your investors see that cost as an increase to the risk of the investment, you may hit a wall when you go to raise funds.

Underwriters can communicate assumptions and projections with the investor relations and education team. The investor relations and education team can likewise communicate investor sentiment garnered from direct conversations to the underwriting team. While investors may not be as informed about broader economic trends, they can provide insight into individual behavior that can lead to raising hundreds of millions of dollars – or tens of thousands of dollars.

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