What is means for a real estate deal to "pencil out", and how to actually get a deal that pencils in 2021.
I recently ran a poll on LinkedIn, asking real estate investors what part of the investing process is giving them the most trouble in 2021. Here’s how it broke down:
While some investors are having trouble securing debt and/or equity to invest, and others are most affected by economic and regulatory uncertainty, the overwhelming answer is that it is challenging to find real estate investment deals that pencil out.
What is “pencil out”? And why is it so hard these days?
This term came about in financial circles and is used commonly among investment bankers and real estate investors. TheFreeDictionary.com offers two definitions for “pencil out”:
verb: To calculate or estimate (projected profits and losses or other figures)
verb: To appear likely to be of sufficient benefit to justify the projected costs
So for a project to “pencil” or “pencil out” means it appears worthwhile based on initial underwriting.
The word Pencil is used rather than Pen to imply that the numbers can be erased and recalculated. They are not final. This is why I say a project that pencils out appear worthwhile based on initial or preliminary underwriting. As you learn more, you change assumptions and allow your financial projections to update accordingly.
Real estate investors have several metrics they might focus on when determining if they like an investment deal. Some of the most common metrics are Cash Flow, Equity Multiple, Cash on Cash Return, and Internal Rate of Return. We’ve written about some of these previously, which you can find below:
Real estate prices are rising, and they have been for quite some time. That’s true on an absolute basis (dollars per square foot), and also on a cap rate basis. Cap rates measure the ratio between a property’s price or value, and that property’s income. So buying real estate income is more expensive.
All else equal, lower cap rates lower a property’s potential cash flow for an investor buying that asset. While price appreciation also drives investment returns, and it can be argued that lower cap rate properties are more likely to appreciate faster (usually true), many investors targeting Cash Flow and Cash on Cash Return metrics will have trouble making a low cap rate deal pencil.
If tenants cannot, or do not, pay rent at a property, the whole model falls apart. Social and economic disruption to the economy can cause tenants to miss rent payments in a variety of ways, including:
All of these can affect the underwriting of a real estate investment deal.
Sometimes a property’s income can be affected by new and unforeseen regulations. Before COVID ever started, several states were changing the rules about how real estate investors can operate their properties. New rent control laws were passed in California, Oregon, and New York in recent years, impacting both new and existing investments.
During COVID, the Center for Disease Control under President Trump banned the practice of evicting non-paying tenants under the banner of public health and safety. That mandate was later removed, but then brought back again under President Biden’s administration. The Supreme Court stepped in to shut it down again, citing the CDC’s lack of authority to make such a decision. Now Congress may bring this eviction ban back at the federal level again.
Feel certain about how the rules of the game may further evolve in the coming years? If you do, you’re in rarefied air. Uncertainty makes it hard to confidently underwrite rent collections, rent increases, and expenses.
The Federal Reserve, the President, and numerous news outlets are preaching that the recent rise in core inflation is “transitory”. Many financial experts are wary of that explanation. Continued inflation can dramatically alter the expected metrics of real estate investments, for better or for worse. Stress testing for inflation in a real estate investment model can be a difficult situation for making bold and confident investment offers.
Full, disciplined underwriting means entering conservative estimates of key deal levers including rent and other income, expenses, and financing costs. Underwriting should be informed by market comps, trends, and up-to-date data that may affect the property’s performance.
While disciplined underwriting may actually whittle down the number of deals that pencil out for an investor, as they may underwrite too conservatively and lose the opportunity to a more aggressive investor, it’s actually the only way to really get any deals that truly pencil out. Aggressive investors that overpay for assets never have deals that pencil out.
Once you have your investment strategy and underwriting approach set, then think of it like a sieve. You pour sand through, let all the sand go, and hope to collect something interesting that doesn’t fall through the cracks. The more sand you pour through the sieve, the more chance you’ll collect something worthwhile.
So it is in real estate investing. You need to source, and underwrite, more deals in order to find the qualified ones. This can be done through listing portals, brokers, or through contacting sellers directly.
Taking deals that might fit your investment model and “working backwards” toward the purchase price is a classic strategy. Two considerations need to be kept in mind here:
Compare your maximum purchase price with the asking price, whisper price, or other best indication of the seller’s minimum acceptable price. The deal officially “pencils out” whenever your maximum purchase price is greater than the seller’s minimum acceptable sale price.
It would be wonderful to make an informed, fully underwritten offer on each and every interesting property within your target market. But there’s not enough time. Short-cuts are needed to work efficiently and put out enough offers to gain traction on deals done in today’s environment.
For value-add real estate investments, determining the precise pro forma NOI is the most intensive part of the deal analysis. Therefore, the biggest possible short-cut is to delay your full pro forma underwriting until you find whether the deal pencils in other ways. Take the current Net Operating Income at face value (or NOI + a growth factor), combine that with accurate financing assumptions, and see if the asking price is even within range of acceptable returns.
This doesn’t eliminate the need for a full, disciplined underwriting. If the deal doesn’t pencil at this stage though, it redirects your time and effort to other deals. Once you find deals that could work, head back to apply disciplined underwriting.
Let’s not skip too quickly over the phrase “accurate financing assumptions” above. In an age of low cap rates and varying financing structures available, good or bad financing assumptions can make or break the deal. We’ll toot our own horn here, providing the industry’s first, free financing and investment calculator available as a browser extension. You can load up this calculator on any website (like Loopnet, CREXi, or a broker website), choose a financing program, and see potential investment returns. It doesn’t underwrite the Net Operating Income of a property — you’ll need to do that after saving your list of deals that could pencil out.
Interest rate caps are implemented by lenders to protect borrowers from potential rate increases. Capital Advisor Freddy Johnson explains in-depth how rate caps work, why they exist, and what to expect if coming into contact with them.