How to Underwrite an Apartment Deal

By Percy Nikora, Owner/Co-founder

How to Underwrite an Apartment Deal - COMPRESSED

Underwriting is an essential part of the decision making process when you’re looking to invest in multi-family – apartment – real estate. This is the process you go through to observe the market conditions, characteristics of the apartment building itself, and any extenuating circumstances.


Here at Penn Capital we use a proprietary algorithm which models the information we find most relevant for decision making. Our models are highly complex and detailed, helping us to seek out the deals that fit best with our investment strategy. It took us many manhours over the years to polish and refine our modeling.


No matter what system you’re using, no deal can be modeled out perfectly. What you’re trying to do is get the model as close to reality as possible. It just needs to end up in the right ballpark. If your initial projections are too far off, you might end up in bad shape as the deal goes on.


When underwriting, your goal is to identify all of the risk factors associated with a specific deal. You can break this down into a few different phases, starting with observing the market.

Looking at the Market


The market is always the first place you need to look. If the market has the right conditions, you can move onto the next stage of observation. But, if the market itself doesn’t fit well with your goals, no building can make up for that.


Look at these factors specifically:

  • Job Growth
  • Population Growth
  • Number of Households
  • Household Volume Growth


In terms of importance, households are more important than population. Households, meaning family groups, rent apartments. It’s a better metric to judge how large the tenant market is and how it’s changing over time. Pay specific attention to new household migration into the area. This is a good sign that demand for apartments will grow.


Job growth also gives you valuable insights into the market. It’s a good metric for understanding the position your tenants would be in to pay rent. High job growth is a good sign that there will be more viable tenants as the households grow.


If we’re satisfied with the market conditions, we will move onto the next phase of underwriting.

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Cash Flow Analysis


In our system, cash flow analysis consists of looking closely at the last 12 months of expenses and other related information. This is the first basic round of checks a property has to pass through to go on to further due diligence.

We will dissect a few things in the cash flow analysis phase, including:


  • Rent Roll

    Rent roll refers to the rent currently coming in as income. Revenue numbers come from snapshots of the rent roll. Base your income models off the trailing 3, 6, and 12 month rent rolls. Looking back 12 months is best, so you can avoid inconsistency and spot any issues from the beginning. Seasonality and some short-term events may have impacted certain months, so having a 12 month rent roll helps you see the bigger picture.


  • Vacancies

    If a property is already occupied, what is the current vacancy rate? Many value add properties are not fully stabilized yet and may have high vacancies from the beginning.


    Lease expiration dates are one of the more important aspects to look at with vacancies. For the tenants who are already occupying the building, when do their leases expire? This is going to help you understand how well the building lines up with your needs and your strategy.


  • Weighted Average Rents per Unit

    Use the weighted average rent to help you establish the growth potential for future rents. Just take the income from weighted average rents and multiply it by the total number of units.

For many investors or developers, looking at month over month cash flow statements seems like overkill. However we find it’s worth the extra time for value add projects, especially when you’re dealing with lease up situations. By looking closely at the monthly finances of a property, you’ll get a more complete picture of your expected default risk and how long you could get into construction before running out of reserves if you took on the project and things went sour.

In-Depth Market Analysis


If we get past the first hurdles, it’s time to bring in more of the team and take a deeper look at the characteristics of the market and its suitability. At this stage, we would bring in the asset management team to be involved with market studies and market surveys to understand more about rent and trends in the area.


Pay close attention to the capex (capital expenditure) budget for any value add properties to ensure it fits well in the market conditions. Test the budget to see what it would take to match your unit to the quality of the top 5% market rent leaders in the area. If it’s not feasible to bring the units up to that quality or operational level, look for the option that would be most feasible for your projections.


The last step in this phase is to go in-depth with the property management team. Look at the intended lease up schedule and model out lease turnover if it’s a heavy value add redevelopment. Model out construction cash flows, capex spending, project timing, and anything else you can possibly need to predict.

Projecting Out


Projecting out big dips or changes in the market helps you see what might happen if the market takes a turn for the worse. Run projections with increased cap rates in order to see what would happen if the market softens in the future. If a deal works on a softened market, it will almost definitely work in an average or favorable scenario as well.


What you need to do is find deals with enough padding so that when you exit you will have less refinance risk or default risk.

Why Project Out?


Projecting out helps to eliminate a lot of deals when you project worse cap rates and market conditions. However, focusing just on making money through fees, building up your portfolio, or engineering deals to look as good as possible with unbelievable growth rates leads to failed deals. Here at Penn, we are in the business of making deals for the long run. If we don’t buy good deals or buy deals only with a short term focus, that will come back to bite us.


In tight markets, some people buy properties for unbelievable amounts expecting the market to continue growing quickly. Just because there has been consistently exceptional growth doesn’t mean it will maintain forever. If your models only work when high growth is sustained, you’re in a dangerous position. Don’t bet on constant growth because you’ll lose big when the market tightens.


What happens if there’s an adjustment or rent correction in your market? Even if the economy is good and job growth is continuing, your tenants can only afford rent based on the wages they’re receiving. Wages need to keep up with inflation and growth with jobs or your target demographic of residents isn’t going to be able to afford to live in your units. You need viable tenants, which means you need to project out to see how wallet share enters the equation.


What is the market average wallet share that people have to pay for rent versus what they make annually? Thirty percent is average in many larger markets, which can grow to thirty five percent or beyond in some markets. In areas where the wallet share for rent is already high, it’s not feasible to raise the rent by 6%, even if that’s what you need to make your numbers work.


You only have so much room to stretch tenant wallet share before you completely erode the viability of the tenant and push them closer to default risk. Ideally, average household income should be significantly above the expected rents. You have more room for growth leading to higher potential yields and lower risk long-term investments.

Market Research for Underwriting


What does market research during the underwriting process involve? Here’s a quick snapshot of what we look at and why.

Household Numbers


As mentioned above, household related numbers are one of the main metrics to look at in a market. Look specifically at the number of households, household growth, and net immigration of new households.

Job Growth


Look at the statistics for job growth in the area. Job growth and wage growth are directly related to rent growth over time. Ideally, there should be a steady 2% job growth.


With job growth specifically, you want to look for industry diversity. New expansions and a variety of business types driving the industry means a greater likelihood for stability. You don’t want to end up in a market powered by one main industry when that industry experiences a downturn or crash.

Markets Good for Landlords


Market regulations will have a strong impact on your financials. You may have higher risk or a lower NOI in areas where local laws and regulations are tenant-friendly rather than landlord-friendly. An ideal marketplace is one that has regulations friendly to landlords. This usually means lower costs for you and less risk of missing out on rent for any reason.

Income Tax Levels


We tend to prefer markets with little or no income tax. This leaves more money in the hands of the consumer and lessens the tax burden for us and our tenants.

Trend of immigration


It’s a good idea to look broadly at markets and try to spot those which have a higher trend of immigration of people. One example of this is the sun belt, which includes places like coastal California, Florida, north Texas, and the Carolinas. These areas tend to have a higher immigration rate, making them better markets for housing services.

Quality of Life is important [especially cost of living in the area]


Observing different quality of life metrics can help you get a feel for the condition within the market and how much room there is for rent growth. Cost of living is the biggest thing to look at, because it gives you some context to establish the risk of tenant default and limitations on rent growth. Higher cost of living usually means less room for rent growth and higher risk of tenant default.

Estimating Costs


During the later stages of underwriting, once you’ve established the suitability of the market, you need to take a close look at the estimated costs of the project as a whole. Do this by estimating capex and operating expenditures.


To get the best estimations we can, here at Penn Capital, our team benchmarks using data from projects we’ve done in nearby or similar markets. If we don’t have the data available directly, we will pay for databases from local property managers or apartment buildings.

Hidden Costs


Before you commit to any project, you need to figure out exactly what you’re getting into. Bring in experts, such as engineers, contractors, foundation teams, and other relevant professionals. Have these guys do deep dives into the functionality of the project to dig up hidden project costs, especially the deferred maintenance costs we can expect to face.


Some costs are expected and known from the beginning, but other issues could be uncovered during a thorough inspection of the building. You need to know about these as soon as possible.


Deferred maintenance costs usually don’t align directly with tenant rent increases, but they’re necessary anyway in order to get tenants. Granite countertops and new vanities might improve rent prices, but no one will live in a building with a leaking roof or a cracked foundation. Delaying deferred maintenance builds up a risk of creating a bad situation down the road.


There’s always deferred maintenance on every property because of how depreciation is done for apartments. Just make sure there’s nothing hidden that will surprise you later with an enormous hit to your budget.

Operational Underwriting Assumptions


Beyond the costs we can quantify through a database, there are other costs that can be estimated by a professional in the right field.


Get a tax advisor involved to figure out what taxes would be on the property. Look at utilities and utility upgrades to save over time. Marketing costs are fairly standard in all markets because of digital marketing, so these costs can usually be assumed with little error.


If the property is already running, work with the property manager to understand payroll and labor costs. Make sure these costs are justified by the needs of the building and local market labor rates. Fixed costs like insurance, taxes, and management fees are usually easy to come up with because you can go based on what the building is already working with.


Benchmark all the controllable costs, then bring in specialists to come up with fixed cost estimates before you buy any property.



Underwriting is a complex process. But, doing it right helps you avoid bad deals and only land in the deals you want to carry for the long-term.


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