How to Underwrite Real Estate Deals during a Recession
by Christopher
“The key to building wealth is to preserve capital and wait patiently for the right opportunity to make extraordinary gains.”
- Victor Sperandeo
There are some in life that willingly jump out of planes, base jump from mountains or swim in shark infested waters for the thrill. Those who live for the rush and risk life/limb to achieve it. Risk takers they might be called by some. In fact, my brother happens to be one of them!
Yet, let me tell you that investing is where you want to take calculated risk and most definitely not take the same approach of risking it all, all the time. In our current market, some would argue those who are still investing or using bank debt to buy overinflated real estate, are indeed risk-takers and foolish.
We are actively investing at this peak of a market, in a recession, and doing so with confidence while many are waiting for the crash. How do we invest with confidence? Today, I’ll share four simple tips to underwrite real estate investments that will help you preserve capital and protect your investment from day one.
If you are a passive investor, these will help you verify if a deal is conservative enough to your liking. If you are an active investor, these tips will help you purchase better properties and sleep like a baby through it all.
Let’s jump in…
Tip # 1 Start with the Sale in Mind
This is a simple start. When you are looking a real estate deal, always start with the sale in mind. So if you plan on selling in 6 months, 12 months or 5 years, what will be your price?
What this tip means, is know the number you are either going to sell at for your game plan. Now, take 10-15% off that number. Yes, I said 10-15%. If the deal still makes sense, proceed. If it doesn’t, you shouldn’t be buying it during a recession.
In commercial syndication, many groups will always look to have their entry cap rate be equal to or higher than their exit cap rate. This is the same principle as the above, it ensures they are selling at similar pricing as they bought, according to cap rate, thus baking in a level of conservatism.
Remember the goal is to mitigate risk and be conservative, especially now.
Ok but what if you won’t be selling? Let’s look at Tip #2…
Tip #2 Have Multiple Exit Plans
Even if you plan on never selling the property, have at least 2 other options if you need to. This means plan for a refinance in year 2-3 or look at if the property would work as short-term rental instead of a long term rental. The key here is having multiple options if your first plan doesn’t go well.
Smart investors always have a backup plan and this is especially true when buying during a recession.
Tip #3 What is Your Refinance Rate
So we just mentioned refinancing a property and this is a big one to ensure you bake into your numbers on the deal, especially right now. As of 6/16/2023, the Federal Reserve just raised the interest rates by .75 basis points which means 8% interest rates will be the normal for investment loans.
In a recession, raising interest rates is the only card the FED has and they will use it. This means investors need to ensure their refinance timeline adjusts for an increase in rates. If you don’t plan for this increase, you will most assuredly be off on your numbers.
Tip #4 Have Reserves
This goes without saying. Always, always, always have cash reserves when you purchase a property. In our investments, we traditionally put aside at a minimum 5% of our investment as reserves. For specific loan requirements, this could even be has high as 12 months of mortgage/tax and interest payments.
No-one has a crystal ball during a recession and it’s important to have some cash reserves to backup your plans if things do not go according to plan. Case in point, In one property we had, someone stole 3 A/C units after we purchased the property, the next day!
Reserves are important, especially in a recession.
In Final
Running the numbers on an investment deal should give you confidence to pull the trigger on the investment. Checking some of the items above should add to your conviction in the deal and empower you to take action during a time when many are running for the hills.
Remember, opportunity is often found when everyone is looking left and you happen to look right. Wishing you much success! Happy Investing!