May 8, 2024

Here’s How Underwriting Can Help You Navigate Through Your Deal

Success in real estate investment hinges on a comprehensive evaluation. This includes analyzing finances, assessing potential risks, and projecting returns. A cornerstone of this process is underwriting. Underwriting allows investors, lenders, and all involved parties to thoroughly assess the feasibility and profit potential of any real estate venture. 

This article dives deeper into the world of real estate underwriting, unpacking what kind is necessary and the key numbers behind any deal.  Whether you’re a seasoned investor or just starting out, understanding these factors is, to some extent, a must. 

What is underwriting in real estate?

First, let’s look at the big picture. Sometimes, the concept of underwriting in real estate is used to describe how sponsors and individual investors size up potential deals. Here, it is basically a vetting process to ensure everything looks good. 

But there is also a more technical side. This is where lenders step in and analyze a borrower’s creditworthiness. They will check experience, equity contribution, and even how much debt the deal carries compared to the expected income (debt-to-income ratio). This initial screening helps them decide if it’s worth a deeper dive. 

If all checks out, the lender might send things to their underwriting department for a full analysis. This is where the real crux happens, and the lender decides whether they are comfortable moving forward with the deal. If so, they might issue a term sheet outlining the loan details.  

That said, underwriting goes beyond saying “yes” or “no”. It acts as a compass for investors and lenders, guiding them towards informed decisions. For example, lender, through underwriting process, is “able to analyze the loan application and make sure that they are aware of every possible risk factor, which also includes the aforementioned credit history or credit score of the borrowing side along with the market value of the property and how reasonable it is”. It is also worth noting that this expertise is so valuable that any real estate investment trust or advisory board lacking in-house underwriters should be seen as, somehow, a “red flag”. 

We mentioned that investors and lenders peek under the hood before diving into a deal.  That’s where preliminary vetting comes in, and Fedman Equities has a breakdown of how this process works. 

The preliminary vetting process

  • Sponsor credentials 

Think of the sponsor as the captain steering the real estate ship. They’re in charge of managing day-to-day operations, from finding the perfect location to building it all up and even filling it with tenants. When you’re investing, you’re basically trusting them to follow the plan and make sure your cash flow works. So yes, the sponsor is truly the quarterback of your real estate deal. 

  • Sponsor-provided projections 

Following an examination of the sponsor’s credentials, the next step involves a thorough analysis of the sponsor-provided return projections. It provides a detailed review of the underlying financial data. Specifically, the focus should be on the sponsor’s projected returns and their alignment with current market conditions and the performance of comparable projects in the immediate geographic area. 

You may not want to take the sponsor’s projections at face value. A smart strategy is to view their “worst-case scenario” as your own “best-case scenario” during the underwriting process. This way, you’re basing your decision on a more conservative outlook.  The key question: Can you stomach the returns even in the worst-case outcome?  If not, maybe this deal isn’t the perfect fit. Remember, any profit exceeding that worst-case scenario becomes a sweet bonus for those who choose to invest. 

  • Pro forma estimates 

Getting comfortable with a document called a “pro forma” is key.  It’s like a roadmap for the property’s finances, usually presented in a spreadsheet. It shows all the expected income coming in and the expenses going out, broken down nice and clear. 

Depending on the deal, there might be extra details about construction costs and ongoing operational expenses. This is more common for new buildings or major renovations. For existing properties already running smoothly, the pro forma will be more basic. 

The important part, no matter what kind of deal, is for you, the investor, to be a watchdog. You may want to double-check the sponsor’s numbers in the pro forma, for example, question yourself do they seem realistic considering the current market and how things might change in the future? 

  • Floor Plans 

Eagle-eyed investors might also want to peek at the building’s floor plans. These are handy, especially if you want to get a feel for space. After all, good layouts attract tenants, which can boost those rent projections. 

But floor plans aren’t set in stone. The real picture includes things like who lives in the area, how old the building is and its condition, where it’s located, and a whole lot more. Don’t forget to consider future expenses too, especially if you need to rework the layout to make the property shine. It’s all about finding the right fit for tenants.  

The secondary vetting process

After an investor gives a deal a thumbs-up in the initial round, they are more likely to dive deeper with a more thorough vetting process. According to Feldman Equities, here’s what that usually entails. 

  • Site visits 

Glossy brochures and financial projections can paint a pretty picture, but for a commercial real estate investor, seeing is believing. A site visit isn’t just about the property itself – it’s about gathering intel on every aspect that can impact your bottom line. Walking the grounds lets you assess its condition firsthand: are there hidden repairs needed to meet your return goals? Is it a top-tier Class A building or a value-added project requiring more work? 

A site visit allows you to experience the neighborhood firsthand, such as whether it’s accessible, does it boast nearby amenities for potential tenants, or what’s the vibe. Understanding local demographics and potential crime rates adds another layer of information to your decision-making. As commercial real estate is a significant investment, a site visit plays a critical role in turning that initial “maybe” into a confident “yes” before you commit your hard-earned capital. 

  • Comp prices 

Investors use “comp prices” to see how much a deal is worth.  They compare the property on the table to similar ones nearby. They dig into details like rents, occupancy, the size of the units, and any extra amenities to get a clear picture of value. 

  • Legal compliance 

Being investors means we are not fans of surprises, especially when it comes to legal ones. Before diving in, it is important to make sure the property is playing by all the rules. For instance, lenders financing a brand-new building will want to see all the “entitlements” lined up.  Think of them as building permits and zoning approvals – basically, the green light needed to make the sponsor’s vision a reality. Investors might also do a title search because this ensures the seller actually owns the property, and that the title is clean, meaning there are no hidden claims or liens against it.   

  • Tenants’ payment 

A big part of commercial real estate vetting is figuring out exactly how much money the property brings in from tenants, and when they pay it.  This is where “lease audits” come in. They act as financial forensics for the property’s income.  Underwriters will comb through the leases line by line to confirm the amounts tenants are paying, when those payments are due, and if everything is signed off properly.  This helps them predict the property’s cash flow – how much money comes in and goes out – and spot any potential problems that could affect your returns later.  Basically, it’s about making sure the income picture is 200% crystal clear before you invest. 

  • Appraisal 

Most of the time, the lender wants a professional opinion on the property’s value, and an appraisal is what they prefer. Appraisal can be seen as a report card for the property, with a grade based on what similar properties are selling for (market comps), how much income it generates (net operating income), and a special score called a “cap rate.”   

An appraiser, chosen by the lender’s underwriting team, does all the number-crunching and delivers the verdict. Now, if the sponsor doesn’t like the grade, they can argue their case and pay for a second appraisal. In that case, the lender usually splits the difference between the two values to reach a final price tag. 

  • Occupancy history 

Without doubt, occupancy history is a key metric for investors. Stable properties with high current occupancy are a good sign. For fixer-uppers with lower occupancy, investors look at both starting and post-renovation rates. Brand new buildings rely on “market absorption averages” to estimate future tenants. But remember, vacancies do happen. Even in hot markets, plan for a 5% buffer in your calculations. In markets with higher vacancy rates, consider a 10-15% buffer.  Factoring in vacancy is like building a safety net for your investment, keeping it healthy and protected from unexpected empty spaces. 

  • Pro-forma financial analysis 

The pro forma is like a financial crystal ball for investors. It shows a detailed breakdown of the property’s income and expenses, line by line – projected and actual. Here’s the catch: how accurate this crystal ball is truly matters. It helps investors figure out what kind of returns they can expect. 

For those who are worried or doubtful about facing these financial talks, it’s suggested to just call in a financial consultant or advisor. They are the best allies who can help you understand the deal before you put down a heap of money. 

  • Budget analysis 

The pro forma can analyze key figures like net operating income (NOI) – essentially the property’s profit after expenses.  They are also capable of comparing current and projected cash flow, considering any planned improvements. However, the most crucial factor for investors is understanding the cash-on-cash return. This metric reveals the property’s true earning potential, offering a clear picture of its underlying value. By examining these core financial indicators, investors can make informed decisions about their potential return on investment. 

After all, before you invest your hard-earned cash, you may want to be sure the sellers (asset managers and developers) have done their homework.  Underwriting in real estate is like a safety check, a way to identify any potential problems with the property you’re interested in. Ready to take the first step? Our Friday Open House can help! Save your seat every Friday with our market leaders and see how we can help you navigate the process to secure your first deal! 

Disclaimer: The blog articles are intended for educational and informational purposes only. Nothing in the content is designed to be legal or financial advice