After many years in the retail real estate industry, I've come to value the concept of conservative underwriting deeply. In simplest terms, underwriting is the process of evaluating a property’s risk and value before deciding whether or not to purchase the property. Specifically, it involves forecasting revenues, expenses, debt obligations, and ultimately, the financial performance that will dictate returns to investors.
But what does it mean to approach underwriting conservatively, and why is this crucial? Let me take you through it.
The Basics of Underwriting
Underwriting begins with predicting the revenue a property will generate. For instance, in the case of a shopping center, this means estimating tenant rents, potential vacancies, and the costs associated with replacing tenants. You need to consider both "hard costs," like construction requirements and tenant improvement allowances, and "soft costs," such as legal fees and brokerage commissions. These factors all feed into the revenue stream we project over a typical five-year investment horizon.
There are essentially two kinds of underwriting that can be done before purchasing a property or beginning a project:
- Aggressive underwriting: Relies on optimistic projections to present higher potential returns. It assumes rapid rent growth, high occupancy rates, and lower cap rates upon exit without significant justification. As I’ve observed, an operator can manipulate performance on paper by inflating revenue growth and underestimating expense growth, creating an overly favorable return.
- Conservative underwriting: Focuses on realistic and cautious assumptions. It incorporates modest rent growth, anticipates potential tenant turnover, and uses stable or slightly increasing cap rates for exit valuations. For example, if you think a tenant is not strong or their occupancy cost is too high… you’ll write that rent down immediately. That’s conservative underwriting.
Components of Conservative Underwriting
Conservative underwriting is all about setting achievable expectations. This means being cautious with revenue projections and assuming moderate growth at best. We resist the temptation to inflate expectations or rely on optimistic scenarios to justify higher property valuations.
Basic components included in conservative underwriting practices:
- Realistic Rent Growth: Instead of assuming rents will rise by 5% annually, we might only project 2% growth, especially if current market conditions are uncertain.
- Moderate Exit Cap Rates: When estimating the property's value at the end of the investment period, we use a conservative cap rate. This approach avoids overstating the future sale price.
- Accounting for Risks: For instance, we assume some tenants won't renew their leases and factor in downtime before finding replacements. This ensures we're prepared for potential revenue dips.
One practical analogy I often use is this: If you buy a property generating $1 million in net operating income at a 10% cap rate, you’ve paid $10 million. A conservative approach might assume only modest growth in net operating income over the investment period and maintain the same cap rate upon exit. This contrasts with an aggressive underwriter who assumes significant NOI growth and a reduced cap rate, projecting a much higher exit price. The latter creates enticing numbers but involves far greater risk.
Benefits and Risks of Conservative Underwriting
Underwriting is important in evaluating investment opportunities because operators like us must be confident that we can hit or exceed the performance we estimate. A conservative approach builds that confidence by setting realistic expectations.
Benefits of Conservative Underwriting
One of the greatest benefits of conservative underwriting is the buffer it creates when things go wrong. For example, if a tenant unexpectedly vacates, our team’s projections account for downtime and the costs of re-leasing the space. This means the investment can still perform even if the unexpected happens.
A great example comes from one of RockStep Capital’s recent projects, Manhattan Town Center. We estimated conservatively that net operating income would stay relatively flat for five years, and in the first year, we were 35% above our estimate of net operating income. This performance allowed our team to return 20% of the original invested capital in the first year, exceeding expectations. This kind of return creates a lot of goodwill with investors.
In the long run, it’s better to under-promise and over-deliver than to set expectations you can’t meet.
Risks of Conservative Underwriting
Of course, there’s a balance to strike. If the RockStep team is too conservative, we risk missing out on great opportunities. I’ve experienced this firsthand with Antelope Valley Mall in Palmdale, California. We were a tad too cautious in our underwriting and ultimately lost the deal to another buyer.
Looking back, it’s been a fantastic investment for the other company and a reminder that being overly cautious can cost you.
At the same time, I’ve seen the downside of aggressive underwriting from others. Some sponsors inflate expectations about rent growth, occupancy, or exit prices to make a deal look more attractive to investors. When those projections fall short, it erodes trust and damages their reputation.
At the end of the day, I’d rather walk away from a deal than promise returns I can’t deliver.
Avoiding Common Pitfalls in Underwriting
Avoiding common pitfalls in underwriting is essential for achieving consistent, reliable investment performance. Over the years, I’ve learned how aggressive assumptions can lead to overvalued properties, underperformance, and disappointed investors. Several practices can result in failure in property underwriting.
1. Overly Optimistic Rent Growth Projections
One of the most frequent mistakes I see is overly optimistic rent growth projections. It’s easy to assume that rents will grow significantly, but if there’s no basis for that growth, you’re setting yourself up for failure.
For example, if the market rent rate is $20 per square foot, an aggressive underwriter might project $25 within a few years. I keep my projections modest, assuming $21 or $22 based on realistic trends. This ensures that even if market conditions soften, the deal can still perform.
2. Unrealistic Occupancy Expectations
Another common pitfall is inflating occupancy projections. If a property is at 85% occupancy today, don’t assume it’ll jump to 98% in three years. Instead, the RockStep Team builds on realistic expectations, often projecting a modest 1-2% annual increase. Our team also factors in potential tenant turnover and downtime for re-leasing.
Overall, you must assume some tenants won’t renew and account for that in your underwriting. That’s the conservative approach.
3. Underestimating Expenses
Some sponsors underestimate or ignore the reality of rising expenses. Property taxes, insurance, and maintenance costs rarely stay flat. A good rule of thumb is to assume expenses will grow by 2-3% annually. Ignoring these increases can lead to inflated NOI projections and unrealistic returns. By planning for higher expenses, we ensure our partners’ investments remain viable despite rising costs.
4. Aggressive Exit Cap Rate Assumptions
Exit cap rates are often manipulated to make a deal look better than it is. You can show a very good return by buying something at a nine cap and exiting at a seven-and-a-half cap, but what’s the justification?
For instance, if I add investment-grade tenants like TJ Maxx or a grocery anchor, that might justify a lower cap rate. But without those fundamental changes, projecting a lower cap rate is just wishful thinking.
5. Excessive Leverage
Leverage is a powerful tool, but it’s often overused. If you see a property levered at 70-75%, showing a high IRR, you must recognize the extra risk that leverage introduces. High debt can make returns look appealing on paper, but it leaves little room for error.
For our team, we prefer to keep leverage between 50% and 65% of the property’s value. This gives us flexibility and ensures we’re better positioned to weather market fluctuations or downturns.
6. Ignoring Capital Expenditures and Reserves
Older properties, in particular, require significant reserves for unexpected maintenance. A reserve is a specific amount of money set aside by property management to cover the physical repairs needed on a property.
The older the property, the larger the reserve should be. Roof repairs, HVAC replacements, and parking lot maintenance are just a few examples of unplanned expenses that can derail an investment if not accounted for. A good practice is to always maintain a rolling reserve and keep plenty of cash in the bank as a buffer.
7. Overlooking Market Risks
Finally, some sponsors fail to account for market risks. You need to figure out if market conditions will be better, the same, or worse when you exit a property. Conservative underwriting assumes that conditions may soften, not improve.
For example, modest assumptions about rent growth and occupancy during an economic downturn provide a buffer that protects the investment. We make sure our underwriting is strong enough to withstand bad scenarios, not just good ones.
The Value of Conservative Underwriting for Investors
Investors need to value conservative underwriting because it builds trust and minimizes risk. When you inflate expectations and don’t meet them, you lose credibility with investors and lenders. Conservative underwriting ensures realistic projections, protecting against disappointment and maintaining investor confidence.
While aggressive underwriting certainly has benefits, it often hides risks behind inflated numbers. This underwriting approach has an inflated belief in revenue growth, an inflated belief in occupancy, and a conservative belief in expense growth that makes an aggressive deal appear better than it is. By contrast, a conservative approach focuses on achievable outcomes.
Investors should strongly consider partnering with operators who prioritize conservative underwriting practices. While conservative underwriting might not promise flashy returns, it delivers consistent, sustainable growth.
Strategy for New Investors
My advice to anyone new to real estate investing is simple: partner with sponsors who share a conservative philosophy. Look for operators who prioritize realistic projections over flashy returns and focus on building trust by consistently delivering on their promises.
Ask them tough questions:
- What’s driving their rent growth projections?
- Are expense assumptions reasonable?
- How realistic is their exit strategy?
Last Thoughts About Conservative Underwriting
For me and the team at RockStep Capital, conservative underwriting shapes our acquisition philosophy. It’s about managing risks, setting realistic expectations, and delivering on promises. My goal has always been to provide consistent returns to our investors rather than chasing occasional, high-risk wins. As I’ve seen time and again, this approach creates more positive surprises and fewer disappointments.
At the end of the day, conservative underwriting is how RockStep Capital builds trust, achieves results, and ensures the long-term success of my investments. I’ve relied on this mindset throughout my career, and I believe it’s the foundation of smart investing.
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