The Leased We Could Do: Let’s Talk About Vacancy Underwriting…

In these interesting times, we are learning about the extraordinary generosity of people around us.  We have found that people are sharing more than ever. 

Witnessing this is a strong reminder that there is no point in possessing something valuable if you cannot share it.  It is also a reminder that relationships are powerful. 

With that said, and in light of the pandemic, we think it is important to continue our public dialogue with the CF Capital community by touching on some of the core elements in our underwriting process and how they apply to this environment. 

The first element we would like to address is vacancy.

Our approach to vacancy is critical to our underwriting process as it allows us to learn about the health of a broader market as well as the underlying property performance relative to others in a city or town. 

CF Capital’s vacancy underwriting process requires us to remain plugged-in, observant, and adaptable to the macro and micro forces at play, such as unemployment or market supply dynamics. 

The beginning of our process investigates the historical and current performance of a market as well as evaluating a particular property to determine what is realistic and what is expected moving forward.  We then gather the current and historical vacancy figures to compare the market to an individual property. 

This also allows us to see market performance throughout cycles, gathering an average rate, gauging current trends, and formulating an opinion related to various potential outcomes. As we navigate these steps, we consider market forces and property-specific assumptions to determine the practicality of a projection. 

In other words, our projections are based on actual data because we believe that history tends to repeat itself.  Current and historical data also enable us to identify any anomalies, causing us to further examine an individual property.  In such a case, we would perform additional due diligence to discover the origin of the anomaly.  Possible sources might be the operating activity levels of the property manager or the market’s willingness to pay rent at current levels.

As we move onto the next step, it is worth mentioning that it is in our DNA to be consistent in the conservative nature of our underwriting process.  Our general attitude allows us to take great comfort knowing that we are protecting capital by considering the worst case scenario, while remaining optimistic that a property will most likely perform better. 

A conservative mindset also means that our approach does not speculate on the uncertainties (e.g. migration patterns) related to the future of a particular market.  Instead, we stick with what we currently know and consider a thoughtful scenario analysis that includes a best-case and worst-case. 

Typically, we apply a margin of safety in our projections by including a historic-low submarket vacancy rate.  However, with the current pandemic environment, we might run a worst-case scenario stress test by adding a buffer to vacancy.  We can then determine if a specific deal would still work by analyzing the impacts on our model in areas like net operating income, cash flow, and asset value. 

Depending on what the projections reveal, we will either pass on the property or proceed with the next steps of our investment process.

To further illustrate our approach, let’s walk through a hypothetical underwriting process with a particular focus on vacancy. 

Our process begins by collecting data at the national level.   We have gathered that the ten-year historical average of vacancy for multifamily properties is roughly 5.0%.  Currently, multifamily vacancy is below that level at 4.2%, with Class B properties at 4.2%, Class C properties at 3.6%, and Garden Style properties at 4.3%. 

After looking into region-specific vacancy rates and other economic data, we discovered that one of the cities in the Southeast region had potential, especially in Garden Style Class B and C properties.  We will refer to this city as City X.  Multifamily vacancy in this city has been trending downward and is currently 3.0%, far below its ten-year historical average (7.7%) and significantly lower than the current national average.  Unemployment levels this year have spiked from a 3.3% low in March to 9.7% in May, but have shown more resilience than the rest of the nation (13.3%). 

Other economic indicators also suggest that City X is a compelling area for investment and relatively unpenetrated by other multifamily investors.  Within City X we found a Garden Style Class B property in a desirable location with attractive characteristics, including a low vacancy level.  The property has vacancies in 2.0% of its units (versus the ten-year average, 5.0%), and over the past ten years has shown stability with some evidence of mismanagement. 

Proceeding to the more quantitative step in our underwriting process and taking into account the current pandemic, we factor in a unique worst-case vacancy scenario by adding a 2.0% margin of safety to the city’s worst historic level of 13.0%. 

Applying a worst-case vacancy rate of 15.0% and considering our other assumptions, our projections determine that our deal could work.  In this case and depending on other assumptions, we would likely proceed to the next step of our due diligence process.

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