How to Spend Your First 5 Minutes Screening a Real Estate Investment

In a real estate investment opportunity, numerous assumptions are made. The two most critical assumptions to understand and check as a passive investor first are:

1 - Rent Growth Assumptions

a.     Be wary of sponsors underwriting rent growth greater than 3% into perpetuity. This is rarely the case, even if you believe you are investing in a “hot market.”

b.     Make sure the rent growth and expense growth rates match. If the sponsor is underwriting rent growth at 3%, they should have their expenses growing at 3%. In some markets, expect to see property taxes growing at a faster rate than rents, but never the other way around with rents growing long term at a higher rate than expenses.

2 - Exit Cap Rate

In a longer-term hold deal (5+ years), the cap rate should be rising every year. All sophisticated acquirers of real estate underwrite a higher cap rate on sale than the prevailing cap rate at the time of purchase. Interest rates may rise over time which could push up cap rates. The actual property itself will be older upon sale. 

Older properties tend to have more risk associated with them because their tenant quality is often not as strong. There may be more risk of significant capital improvements required for the next buyer, which translates to buyers using higher cap rates. Be skeptical if the going-in stabilized cap rate is the same or lower than the exit cap rate! At Breneman Capital, we conservatively underwrite our deals by expanding the cap rate at 5-10bps (.05%-.1%) per year.

Adjusting Exit Cap Rate On Value-Add Properties

If the sponsor is doing a deep value add deal, those properties are often purchased at very low going-in cap rates because the sponsor is underwriting to a specific IRR or equity multiple. To evaluate how this sponsor is trending up their cap rate, you would need to ask what the stabilized cap rate is today in the market and then confirm they have increased from that cap rate on their exit. The next buyer will not be buying a value-add deal and will be looking at the stabilized cap rate.

Investment opportunities that do not follow the assumption guidelines above run a much higher risk of having investment returns fall short of their initial projections and that is why we are recommending starting with digging deep on these data points. 

Other Critical Assumptions To Check Next

Other important assumptions to check after evaluating rent growth and exit cap rate are:

• Rental rates
• Operating expenses
• Real estate tax adjustments after purchase
• Debt terms

These are more difficult to verify quickly, but these should be vetted and/or discussed with the sponsor as well. Rental rates and operating expenses should be compared with similar buildings/units in the market. Real estate taxes are treated differently in each market. An ideal property tax answer from a sponsor is one or more of the following: (a) they own similar properties and know how they are treated, (b) they are working with a tax attorney who provided them with the numbers in the underwriting, or (c) they spoke with the tax assessor.

For more information on how we would recommend screening a deal beyond this stage, please see Smart Questions to Ask Yourself Before Investing in Real Estate. Or schedule a time to discuss your questions with us directly here CONTACT US.

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