The Specifics of Financial Models With Ironclad Underwriting w/Dr. Jason Williams
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Episode Description
Welcome to the Freedom Point Real Estate podcast! Dr. Jason Williams joins today's episode to answer Jeremy Dyer's questions about underwriting's importance in evaluation, conservative vs risky approaches, red flags in underwriting models, cap rates, and more.
Jason, Founder of the Ironclad Underwriting Mastery, Co-Founder of The Academy Presents, and Managing Partner of Lorren Capital, LLC, has a rich background in real estate investing. His expertise spans from single-family rentals to large multifamily syndications. With degrees in Chemical Engineering from Texas Tech University and a 15-year engineering career, Jason combines analytical precision with real estate acumen, making him a trusted authority in the field.
CONNECT WITH JASON WILLIAMS!
Website: https://ironcladunderwriting.com/
LinkedIn: https://www.linkedin.com/in/jasonwilliamsphd/
CONNECT WITH JEREMY DYER!
Website: https://startingpointcapital.com/
Instagram: https://www.instagram.com/startingpointcapital/
LinkedIn: https://www.linkedin.com/in/jeremydyer
Facebook: https://www.facebook.com/startingpointcapital
Book a Call! https://calendly.com/startingpointcapital/discuss-investing-with-jeremy-dyer?month=2023-12
Summary
Tip #1: Understand the Difference Between Rate Cap and Cap Rate
“Make sure you have a rate cap... it's different than a cap rate. A rate cap is a ceiling on your interest rate, while a cap rate relates to the property’s financial performance." Jason begins by clarifying a common misunderstanding between rate caps and cap rates. For investors, understanding that a rate cap limits how much interest rates can fluctuate on a loan is essential for managing financing risks. On the other hand, a cap rate (capitalization rate) helps evaluate property performance by measuring the relationship between the Net Operating Income (NOI) and the purchase price. Each plays a crucial role in underwriting decisions, and confusing the two could lead to flawed financial assumptions.
Tip #2: Focus on One Market to Predict Trends Accurately
“You need to concentrate on a single market... Once you know everything about that market, move on to a different one.” Jason emphasizes the importance of narrowing down your focus to a single market when starting as an investor. By deeply understanding one market, you can predict trends more effectively, such as rent increases and expense rates, which is crucial for long-term success. This strategic focus helps avoid the pitfalls of being scattered across multiple markets, which could result in shallow analysis and poor investment decisions.
Tip #3: Be Prepared to Underwrite Many Deals Before Success
“Best-in-class sponsors that I've encountered... are writing a hundred deals before they ever enter into a contract on one.” Jason encourages persistence, stressing that it may take underwriting numerous deals before finding one that works. New investors often feel discouraged after reviewing several properties without success, but those with experience understand that reviewing dozens or even hundreds of deals is part of the process. This mindset shift helps smaller operators understand the patience and effort required for success in real estate investing.
Tip #4: Plan for Cap Rate Fluctuations Over Time
“You're just not going to be at the same quality as a 10-year-old property... that’s why you want to increase your cap rate on exit.” Jason advises investors to factor in the natural aging of properties and the likelihood that cap rates will expand over time. As properties age, they tend to have more maintenance issues, and newer buyers will factor that into their calculations. By accounting for an increasing cap rate at exit, investors can set more realistic expectations for returns, making their business plans more conservative and resilient to market changes.
Tip #5: Stress Test Your Underwriting Models
“Most people don’t even know what stress testing is... I’ve only run into one or two people who actually tried to stress test their model.” Stress testing is a crucial, yet often overlooked, practice in underwriting. Jason points out that many investors fail to run different financial scenarios to test how their investments would hold up under adverse conditions, like rising interest rates or higher cap rates. Implementing this practice forces investors to confront potential risks and ensures they are better prepared for unexpected challenges.
Tip #6: Account for Rising Interest Rates
“I also stress test interest rates... what happens if I get it at 6.25% versus what happens if I go on a bridge and I’m looking at 12%?” Interest rates can significantly affect the profitability of a deal, and Jason stresses the importance of preparing for fluctuations. By stress-testing deals with different interest rate scenarios, investors can ensure they can still meet their return targets even if financing becomes more expensive. With rising rates becoming a norm, this type of foresight could mean the difference between a good and a bad investment.
Tip #7: Use Conservative Exit Cap Rate Projections
“Can I still get decent returns to my investors if [the exit cap rate] is a lot higher than anticipated?” Jason encourages underwriters to take a conservative approach when estimating exit cap rates. Since the future market is unpredictable, especially five years down the line, setting a higher exit cap rate ensures that you aren’t over-promising returns to your investors. This approach builds a cushion into the business plan, protecting against market softening or increased competition in the asset class.
Tip #8: Avoid Relying on Pre-Built Spreadsheets Without Understanding the Inputs
“I’ve seen people just blindly input numbers... not realizing what they entered doesn’t change anything in the model.” Many new investors use pre-built underwriting spreadsheets but fail to understand how each input affects the model. Jason points out that this lack of understanding can lead to inaccurate assumptions, which could result in a failed investment. Investors should take the time to learn how their financial models work so they can input accurate data and make informed decisions.
Tip #9: Stress Test for Interest Rate Shocks and Unforeseen Loan Changes
“If I didn’t check that [interest rate], I wouldn’t have gotten the deal and would have lost $100,000.” Jason shares a personal experience of nearly losing a deal due to unexpected loan changes. Stress testing for sudden interest rate spikes and having backup financing plans are critical for avoiding losses, especially when timelines are tight. This tip emphasizes the need to plan for the unexpected and have multiple strategies in place when approaching a closing.
Tip #10: Learn to Fish – Don’t Rely on Others to Underwrite for You
“I’d rather teach you how to fish... but I can underwrite it for you if you really want.” Jason prefers to teach investors how to underwrite deals themselves rather than doing it for them. This mindset highlights the value of building long-term skills rather than relying on someone else to handle crucial parts of the investment process. Learning to underwrite deals independently ensures that investors fully understand their deals and can make more strategic decisions moving forward.
