You're listening to the Master Passive Income Podcast Network.

Hey, guys, Charles Seaman here with Erica McNew.

And thank you for joining us on this episode of the Master Passive Income Multifamily Podcast.

If you want our commercial Real estate success guide, text the word freedom to 33777.

Today we're going to be talking about multifamily underwriting.

Now, a topic that's both interesting and confusing to many.

So we're hoping we can shed some light for you guys by the end of this episode.

Welcome to the Master Passive Income Multifamily Podcast, where we guide you to invest in commercial real estate with a special.

Focus on raising money from others to buy bigger and better deals.

And now here are your hosts, Charles seaman and Erica McNew.

And no one better to talk about it than you, Charles.

So I'm excited about this one.

Oh, well, thank you.

So what is multifamily underwriting?

Well, basically what you're doing is assessing the financials of a property to determine the investment viability.

So in layman's terms, you're seeing if the deal makes sense or not.

So how does that happen?

Well, you're going to be taking the existing financials, and we'll talk about that in a little bit to make that determination.

Why is it crucial?

It's crucial because whenever you make an investment decision, you want it to be based on data and not on emotion.

And having good underwriting and understanding it can help you avoid costly mistakes.

Do you agree, Erica?

I do.

And I think that not doing enough due diligence on your underwriting and making sure that you're calculating things correctly on that could be a costly mistake that could really hurt the cash flow on the asset.

So I think it's critical to make sure that your numbers pencil and that your numbers are accurate.

And I guess we'll get into what some of those numbers should be.

Absolutely.

Well, why don't we talk about some of those now?

What are some of the key ones, Erica?

So I guess the number one would be your net operating income.

And you know, that's calculated.

You have your per door income and then you have it monthly, annually.

You take that annual net operating income and you divide that by the purchase price.

That's how you get the cap rate.

So the net operating income is critical for helping you determine the cap rate.

And also that's where you're starting at before you calculate expenses and all that good stuff.

Right.

So keep in mind, guys, with any valuation in commercial real estate, whether it's multifamily retail, office, whatever it is.

There's two components that are gonna help you figure out that price.

You got the net operating income and you got the cap rate.

So the net operating income is gonna be driven by the individual property you're looking at.

The cap rate's gonna be driven by the area.

So no one property is gonna have the ability to control the cap rate eventually.

That's my goal.

But you'd have to really have a lot of money to buy a whole area to do that.

Most people don't have that type of cloud.

Right.

And I do think that cap rate is, it's something that you look at for sure.

In my experience, you get in there and you truly start to do underwriting at a deeper level after you've gotten under contract on the asset or you're in a letter of intent, period.

And so within that, I think sometimes you'll find the cap rate is misrepresented and sometimes it's better than what they're representing because there was some value add opportunity that they didn't see or we're just neglecting and overlooking.

And sometimes it's not as good as their advertising.

So cap rate is something to just be taken at face value.

But it is a really good metric I think, that we use to help determine quickly if something is worth looking into.

Yeah.

And what I would also say is that different people look at cap rates differently.

So you'll probably hear that throughout the industry, some people use it as a return metric.

To me personally, I don't.

Now, could it be a return metric?

Yes, if you're buying all cash.

Most people aren't buying commercial properties all cash.

Some are, most aren't.

But if you're buying all cash, then it's absolutely a return metric.

If you're not, it's probably more of a barometer than is a return metric.

But what I usually use, it is a reflection of buyer demand.

Right.

Because you're going to see how interested are buyers in an area by what that cap rate is.

So cap rates and price have inverse relationships.

So cap rates go up, price goes down, cap rates go down, price goes up.

So the lower your cap rate, the more demand you have for a particular asset type or product type in the area.

Yeah, absolutely.

And then your debt service coverage ratio.

So as we're looking at different, I guess, expenses, you know, what is the mortgage payment on this going to cost if you're not doing all cash?

And knowing what that debt service coverage ratio is is extremely important too.

What is the how much income is the property bringing in versus what the mortgage payment is going to be?

Right.

And I would tell you that that one there.

But like, I don't consider that necessarily a return metric.

I mean, that's not going to put money in your pocket, but it's probably the most important metric because it's going to tell you how safe the deal is.

Because if you can't pay the mortgage, you're going to have some serious trouble and you'll probably be losing sleep.

Yeah, absolutely.

And I don't know about you, I don't know your experiences, but I've seen like the debt service coverage ratio that different lenders are looking for.

It's fluctuated depending on the market that we're in.

So I know, you know, when the market first locked up, it seemed like they were willing to do it.

Lower debt service coverage ratio, and they've now gone back up.

Like I was seeing 0.8 at one point and I was like, wait a minute, what are you talking about, lender?

And so now, you know, I'm seeing again like 1.2, 1.3.

What do you see, Charles?

What's your experience with that?

So most conventional lenders usually want a minimum 1.2, 1.3.

I would tell you even that's on the low side because the problem is you're only three bad months away from a foreclosure at that point.

Right.

So that doesn't give you a lot of wiggle room.

But conventional lens will be in the 1.2 to 1.3 range.

If you're looking at deals that are challenged and they're going to need some work, you will need different financing sources.

So a lot of times you'll dive into the bridge market or the hard money market.

And when you get into those, they will take some deals that are negative DSCRs, but they're going to typically reserve enough money upfront.

And that's something else you got to build into the underwriting to make sure you got that factored in.

Otherwise you're going to be very surprised at closing when you realize you're quite a bit short.

Yeah, absolutely.

And I guess what are some of the other important metrics that you would.

Say cash on cash return.

That's a big one.

So that's going to be how much of a return they're getting from cash flow.

The larger the property, the lower that number typically goes.

So if you're looking at a 10 or a 20 unit deal, you'll probably be able to find some deals with Double digit cash on cash returns.

If you're looking at a 200 unit apartment building, you're probably finding 6, 7, 8% because you're not getting most times you're not getting as good of a deal on a larger multifamily property as you are a smaller one.

But the benefit is that you're getting scale and there's advantages with that scale.

Yeah, absolutely.

Cash on cash I think is one of the most important metrics that my investors are typically looking for.

And then the internal rate of return would be another one.

Yep, internal rate of return is definitely an important one.

That's probably the end all be all for most investors if they're eventually looking to exit.

If they're not, then the cash on cash return takes precedence.

But it's interesting how market cycles kind of shift that demand as well.

I felt like in 2022 most investors weren't focusing on cash on cash return.

They should have been, but they weren't.

And now a lot of them have probably realized that they need to be focusing on that because none of us can truly predict the future.

Right?

Absolutely.

All very, very important things to look at.

And then what else?

I guess as we are like we're analyzing the income of the property would be another portion after looking at those data points.

And again, I know I keep saying this but having a good property manager is so important as you're looking at the like what is the rental income for the area?

What should you be able to anticipate and what else are you looking at as far as like value add opportunities?

Charles?

I guess like Laundromats is something I see quite often, you know, like the laundry machines is additional revenue opportunity.

What do you see?

You can see a lot of things and I think the nicer the property, the more things you can charge for.

My approach might be a little different because I don't necessarily like factoring in other income is things that I'm going to increase.

I always like that to be a bonus versus something I'm counting on.

But you know, you've seen some people get very creative the last couple of years.

I mean you definitely see laundry income, you see parking income.

Sometimes it can be for properties that have a garage, sometimes it can be for covered parking on properties that don't.

You can see people charge for pest control trash removal.

One thing that's become very popular in the multifamily space in the last decade is valet trash.

You know when you think about it, what is valet trash?

Is somebody coming to you doing to Throw the garbage out.

I always say, boy, but when did our society start needing this?

But it's something you want now, and they'll pay for it.

They'll pay a lot for it.

Surprisingly, absolutely.

Other things can be cable contracts.

Some properties have cable contracts that they're gonna go in there and they're gonna upcharge the tenants on.

They might charge them for renters insurance.

They might charge them for a whole plethora of different things that could potentially be moneymakers.

And those are things that you could add additional revenue streams into the property from.

Very neat.

And I love how you calculate it as bonuses.

That's very, very wise of you to do that.

The reason I do that is because I don a judge in the country that's going to give a judgment for those things.

They would give a judgment for rent, but nobody's going to give you a judgment for those things.

So I never like to count that.

I'm going to increase those.

Very good points.

Wow, very interesting.

So what else?

As we're going through the journey of.

Underwriting, then you got the opposite side, the expenses, Right.

So you got to break down all your expenses.

And one thing that I think people probably make a mistake on is sometimes they only account for what they see, which is a good starting point.

So you have two types of expenses and two types of income.

Also you have operating income and expenses and non operating.

What's the difference?

One goes above the line, one goes below it.

And if you're trying to sell a property, where do you find that most people are trying to move things, Erica, above the line?

Well, if you're selling it below the line because you want to make the value as much as possible, but a smart buyer needs to look at that and figure it out and say, okay, something's missing here.

So what does that process look like for you?

Well, what you want to do is you want to look at the numbers and a lot of times what you're doing, you know, similar to what Eric is saying, I very much recommend utilizing good property management who know the area well.

One thing I'm going to say that's probably a little different than you hear many say.

I hate the idea of using, you know, a certain percentage of the income as what your operating expenses should be.

That's not a good.

That's not a good result.

It's a simple result, but it's not really great.

And what's a more accurate metric is a per unit number.

The problem with that is it's going to vary from area to area.

So that's where it's important to know the markets you're looking at and know the numbers.

And you need to start learning what things cost and you need to be able to build that into the underwriting.

I know that the Southeast is generally going to have higher costs than the Midwest, but both are going to have lower costs than New York or California.

So depending on the area you're looking in, you got to be really adjusting those costs to understand what's typical for that area.

Another thing I would say, and this is probably a big one, Capex.

So capex is generally put below the line.

So it's not something you're going to see included in every set of financials.

But you still need money to pay for that.

Keep that in mind.

If there's no money to pay for it, eventually you're either not doing the work or you have a contractor that's going to be placing a lien on the property.

You don't want that.

That's not good.

Not good.

Don't do that.

Yeah, that's a red flag.

So you got to budget for these things as best you can in the underwriting.

And none of us have a crystal ball.

Right.

So it's certainly not like 100% accurate because nobody's going to be able to do that.

But you try to make reasonable assumptions based on the information in front of you.

So that way you can make an informed decision.

Very, very neat.

So when you're evaluating expenses, you're questioning every line item and what do you find is typically off the most Great question.

So by nature I tend to question everything.

It's just how I am.

Usually it's the repairs and maintenance of the turn course is people are trying to shift as much as they can below the line.

Some people will get very creative and they'll shift maybe even more than that.

But those are usually the two big ones that you'll see.

Interesting.

Yep.

So what else?

After you.

I guess we've looked at different terms, expenses and analyzing income.

Well, market comps, that's always going to be a big thing.

Right.

So you want to understand the market.

So what are similar properties and similar units renting for?

What's the typical occupancy rate for the market?

Now we're recording this in September of 2024.

So as we record this, occupancy rates are very different now than they were a year or two years ago in many markets and they're very different than long term averages for these markets have been.

So you want to look at the current, but you also want to look at the past to get some perspective, understand where you are, but also understand where you've been.

So that way you can kind of predict where you're going.

Yeah, absolutely.

Cap rates, exit cap rates.

So if you're buying a property with the goal of holding in perpetuity, an exit cap rate may not be that important.

But if you're buying it with the goal of eventually selling it, which anybody listening to this, you're syndicating, that's probably what you're doing.

If you're doing a jv, probably what you're doing.

If you're using your own money, maybe not as much, but the exit cap rate and the importance of it can't be understated because next to the price is the second most important thing in your underwriting.

You can literally get everything else wrong and like, that could make up for it.

But it's also the one that's hardest to predict because again, none of us have a crystal ball.

So the exit cap is the cap rate that you're planning to sell or refinance at in the future.

So you're trying to make an educated guess of where prices might be in 3, 5, 10 years, however long your whole period is.

And that's going to factor into the equation.

And how do you, what do you, what helps you come up with that number?

Great question.

So most of my information that I get there is based on people.

I speak with, other investors, brokers.

I generally tend to listen to big money sources.

I listen to institutional investors.

I listen to family offices.

I listen to people with a lot more money than me because I eventually know that what they're willing to pay is probably going to dictate where the market goes.

So if somebody with a lot more money than me is saying that this is where cap rates are going to be, I usually listen to them because that's what's going to drive the market.

Interesting.

Very neat.

And I speak to a lot of brokers as well because I think brokers do have good insight there.

But I also take it with a grain of salt because obviously many brokers are going to go out there with the intention of they have to sell something to make a living.

So I get that.

But sometimes that could skew the cap rates a little bit more favorable.

So I do listen because there is a lot of insight there, but I also get different perspectives just to hear what's out there.

Good for you.

Yeah.

And I guess speaking which, how do you like stress test Your deals.

What do you, how do you maybe manipulate some of the numbers within the underwriting process to make sure that if things did change that you're hedged for that?

Great, great question.

Well, there's a few ways that you don't need to stress that.

So a popular one's a breakeven occupancy.

So that means what occupancy does the property need to be at for you to not be able to pay the bills?

So if that break even number is like 85 or 90%, you're probably paying too much.

If it's like 65 or 70%, you're probably in a safe spot because it's unlikely that you're going to see properties get down to that level and stay at that level.

If they do, it's probably a bigger issue that you need to solve.

Another one is interest rate sensitivity.

So for the last two years there's obviously been a lot of fluctuation with interest rates.

I could only think of the couple of deals that I'm in that we had interest rates in the threes and fours when they first started and now they're in the nines.

So interest rates have changed a lot.

So you need to be looking at that now.

If you're using fixed rate debt, most times that rate's not going to be fixed until you, you lock it, which with a lot of loans that will be closer to your closing date.

If you're using floating rate debt, you want to be underwriting it to whatever the max rate's going to be with your rate cap because if you don't do that, you could wind up on the short end of the stick.

Very, very good advice, Charles, because you know, I was in on a $1.725 million building with a floating rate and did not understand what a rate cap was.

And they pushed it to rate cap every single time they could and it raised 64% within one year and three months.

And that was pretty painful.

I wish I would have known to underwrite and calculate the rate cap.

Worst case scenario still made it work, but it would have been really great to know a little bit more on that.

So good advice.

Yep.

So stress testing is definitely very important.

Another thing you can stress test for is your income and expense projections.

So if you're planning to do evaluate dealing, you think you could increase rents, it's probably worth running a different scenario or two and seeing what it might look like if you're off on those rent increases and you don't get the numbers you expected and another one's terminal cap or your exit cap.

So that's probably the biggest one in multifamily or commercials.

Because the thing is that has such a big impact on the sale.

What do the numbers look like when that exit cap is 50 basis points higher or lower?

And I'll give you a secret, it looks a lot different.

So you definitely want to stress test that because that's going to be a big one.

So then after stress testing, what else is it?

It's financing.

So one thing I think a lot of people don't truly comprehend is how important financing is to the commercial real estate market.

Like I would literally say it's the single biggest driver in it.

Yeah, absolutely.

You know, location, location, location.

A lot of people say those are the three most important words in real estate.

I would kind of agree with that.

In single family.

What do you think, Erica?

I agree in single family.

And yeah.

And on the commercial side, lending, lending, lending is definitely key, right?

Yeah.

You know, if you want to see the commercial real estate market come to a complete standstill.

Yep.

Watch financing dry up.

And once that happens, it makes things very challenging.

Deals don't get done anymore.

And something to keep in mind on that is because they're lending for higher price points.

So when they're lending for such high price points, you know, banks will only lend out a certain portion of their portfolio and their cash to commercial lending, commercial real estate lending.

So especially like when you see smaller commercial banks, they only have so much ability to do commercial lending because it is such higher price points.

So very quickly people can, banks can kind of max out on what they can lend to commercial real estate.

And that's where we see the market dry up like overnight.

I actually had a mentor, March 2023.

God, that was an interesting time in commercial lending.

And my mentor had two office deals, large office deals that fell apart at the table, at the closing table because the lender did not want to move forward on them.

So what do you need to know on the financing side?

Well, you need to know basic terms.

You need to know what type of LTV or LTC you're going to be getting.

So your loan proceeds.

You need to know interest rate, is there any interest only, how long of a term, what's the amortization period?

Because these are all things that are going to factor into the equation with your underwriting.

You need to think, what type of loan am I getting?

Am I getting a short term loan, a bridge loan, or am I getting a long term loan?

Now I'M going to give you some advice that I've learned.

If you're buying a stabilized property, the answer to that question shouldn't be a bridge loan.

There is a purpose for bridge loans, but that purpose is to buy properties that aren't stabilized at discounted prices.

So you can go in there and execute a plan to get it stabilized and then either refinance out of the permanent debt or sell it.

If you're buying something that's 90% occupied, there's no good reason to go out there and be using bridge financing.

Keep that in mind.

Also very important to have a great commercial lender.

And I work with several and I always encourage my clients to speak with more than one, especially on the commercial lending side.

There are just so many different products, so many different things that you can do on the commercial lending sites.

A little bit more creative.

And so speaking with more than one lender is really important.

So always have really good partners.

Yep.

So then, real world examples.

So what are some common pitfalls?

Well, one of the biggest things that I see is people not checking the property taxes.

So in today's day and age, a lot of people want to take the lazy approach.

You'll hear me frown upon that multiple times during this show.

So this will just be one of them.

But the challenge with taking the lazy approach is you're letting somebody else do the work for you and you're not confirming an assumption because you think the broker had it right or the seller's number is right or whatever it is.

You got to erase that thinking from your head and you got to take the extra step.

So you need to be contacting the tax assessor's office.

You need to be asking them when is the reassessment going to happen?

How do you calculate it?

Is the sale going to bump that timeline up?

Because these are all things that factor into your underwriting.

If you have a tax consultant that you work with, you can reach out to them.

They can be a great resource also.

But you need to be doing that homework because there's times that I've seen tax bills double and triple on these deals and even a few times I've seen them quadruple.

And when you're dealing with the six figure number, that's a big mistake.

I think insurance can also equate to that kind of mistake these days.

Definitely being proactive on your insurance, making sure that you are really getting, you know, because that can like make or break equations right now, unfortunately.

So that's.

Yeah, taxes and insurance, you're Absolutely right.

So insurance has been very volatile in the past.

I said insurance would not have fallen into that category, but I think you're 100% right.

The last two years, insurance has been very, very volatile, even when it's not expected.

So you want to be checking those things to make sure you have solid numbers.

What are the pitfalls that we see?

So another pitfall is not budgeting enough money for capex or reserve money.

I probably take a different approach than Moesh.

I probably budget too much money.

I'd rather do that and need to cut down than the opposite way.

It's an unconventional approach, but it works for me.

So I do that because there's two reasons why people fail in these deals.

Three reasons.

You run out of time, you run out of money, or both.

So you want to do the best that you can to make sure that you don't run out of money.

What time.

But in this case, money.

Yep, absolutely.

If you run out of money, it's going to make it a lot tougher with any one of these deals, deals.

This size, when you run out of money, too.

So what is underwriting?

Well, at its core, it's a mix of art and science.

Maybe that's why I like it, because I have to admit, I'm not really a total science guy, but I'm not a total art guy.

I like that blend and it's numbers driven.

But it's also your market knowledge, your risk management, your intuition.

One thing I think that's really influencing a lot of people's underwriting right now is their perspective of the market.

My perspective of the market might be different than Erica's.

So we might look at the same deal a different way.

Maybe she's more bullish or bearish or maybe vice versa.

And that's going to change it because if one person is looking at the same deal and they're using an exit cap of an 8% and the other person's using a 6%, who's going to be a lot more competitive on that deal.

Right.

Perspective definitely goes into it.

So it's certainly an important piece of the process.

Now, one thing I would tell anybody is it's good to have a basic understanding, but you don't need to be an expert.

You need to understand what you're good at.

And if that's not your role on the team, then get somebody on the team who can fill that role for you.

That's what I do.

I love my numbers partners.

Very important.

Excellent.

Well, guys, we want to thank you for joining us for this episode.

And once again, if you do want our commercial real estate success guide, you can text the word FREEDOM to 33777.

And we'll wrap up for this one.

Thanks, guys.