What Is Underwriting in Commercial Real Estate?
Making a financial forecast of the property’s cash flows and Net Operating Income (NOI) is one of the most crucial things on a commercial real estate investor’s to-do list before making a commercial real estate investment. This process is referred to as “underwriting” the property, and the financial predictions that arise are shown in a document known as a “proforma.”
In the financial sector, underwriting is the cornerstone of investment decisions. It is the process of determining the risk and future return of any investment, whether a real estate investor buying a property, a bank making a loan, or an investment banker appraising a company.
What Is Underwriting in Commercial Real Estate?
Examining a loan application to assess the level of risk involved is known as real estate underwriting. To determine the agreement’s viability, the underwriter will consider the borrower’s financial situation and the value of the relevant property.
A vital step in the purchase process is underwriting because it can assist lenders and investors in avoiding underperforming properties. Simply put, the underwriting process for real estate is comparable to the loan pre-approval process. Both examine a borrower’s financial situation to see whether an agreement can be made.
The distinction is that underwriting takes into account the level of risk specifically and frequently requests further information from the borrower. Many investors will learn how to independently underwrite a deal because lenders are only sometimes interested in this thorough procedure.
Underwriting can take many forms, but in commercial real estate, the most prevalent is the use of financial modeling to estimate anticipated cash flows and the probability of those cash flows occurring.
How Is Underwriting Used in Commercial Real Estate?
Underwriting offers a financial prediction of a property’s potential future cash flow from the perspective of commercial real estate. As previously indicated, the borrower and the asset they intend to borrow are carefully examined during this pre-purchase phase.
In addition to requesting a property appraisal, underwriters also check the title to make sure no one else is listed on it and determine whether the property’s location is vulnerable to floods, fires, or other natural disasters—all factors that might increase lending risk.
Underwriting an Existing Property
Investing in an existing commercial property may obtain information about its past performance and better understand how it would fare under your management. You have the good fortune of knowing information about potential vacancy rates and tenant behavior, such as:
- The likelihood of a tenant’s lease being renewed when it expires.
- the present tenants’ leases expiring during the hold period
- the anticipated costs (tenant upgrades, leasing fees, and downtime) to keep the current tenant in the property or get the space released
- The property’s anticipated market rents when the current leases expire
Underwriting a Development
Most commercial real estate underwriting considers the past of an existing property. What happens, though, if there is no property past to review?
Although more complex, the underwriting process for a development is the same as for an existing building. You must still predict the property’s cash flow over a given time; the only difference is that you must take the costs and time of the construction stage into account.
Before any revenue is made, development needs to be funded upfront, and it takes time to get the site approved for construction before it can be finished and rented out. Even if the development proceeds according to schedule and budget, it is difficult to predict how long the building might be empty, even though tenants can pre-lease it.
What Are the Most Important Underwriting Inputs for Commercial Real Estate Loans?
Many factors and studies go into the underwriting process, but a few stand out above the rest. You and your lender can make several assumptions regarding the performance of your future property thanks to research into these inputs.
The accuracy of these assumptions will determine whether your possible real estate investment is a success or a loss. Thus, they must remain on the conservative side.
Entry and Exit Cap Rate
The purchase and selling prices of the property are the main determinants of investment return metrics more than any other factor. The property’s year one net operating income is divided by the anticipated purchase price to determine real estate’s entry capitalization rate (or “cap” rate).
To be sure that this cap rate is appropriate, it should be contrasted with recent sales of comparable properties. More significantly, the entry cap rate also serves as a benchmark for the exit cap rate. The underwriter selects the exit cap rate to establish the sales price after the investment period.
The entry cap rate should serve as a guide and be modified for anticipated market conditions at the time of sale. Because the final sales price significantly impacts the investment’s total returns, the exit cap rate assumption must be conservative.
Generally, investors should expect the cap rate to rise by 2% to 3% each year the investment will be held. Therefore, the exit cap rate should be in the range of 7.2% to 7.8% if a property was bought with an entry cap rate of 6% and the projected holding time is 10 years.
Vacancy Rate
When purchasing a multi-tenant property, there would be some vacancies during the holding period. The underwriting model must have a line item for the vacancy to account for this. The property type, tenant quality, number of units, location, supply and demand, and general economic conditions are some of the factors that influence the vacancy assumption.
Physical vacancy, or the number of vacant units, impacts a property’s gross rental income and capacity to finance its operations. As a result, it should be reduced as much as feasible. As the property is being repositioned in a value-add investment, the vacancy rate may initially be high, but it should eventually settle.
Stabilized vacancy should be calculated at 5% to 10% of gross rental income as a rule of thumb. Any significant variation from this should be supported by as much information as feasible.
Rent and Expense Growth
Many factors drive inflation, such as economic conditions, property location, seasonality, supply, demand, etc. When it comes to commercial real estate, it usually works in your favor. The price that can be charged for rent and utilities rises along with the cost of products, services, and living; sadly, the price of running expenses also increases.
Forecasting some operating costs may be more straightforward than others. For instance, contracts for maintenance and landscaping can be extended over time, but those for property taxes and insurance premiums cannot. In general, it is possible to forecast that both the revenue growth and the spending growth percentage will increase by 2% to 3% per year.
Financing Terms
Knowing all the terminology associated with investment real estate can never hurt because your commercial real estate loan conditions may change over time. Knowing all the loan parameters, including the interest rate, duration, amortization, loan-to-value ratio (LTV), and loan amount, is important to predict the debt’s cost effectively.
Capital Expenditures Reserves
Over time, things wear out, and the property’s physical condition deteriorates. As a result, repairs and replacements are required. It is common practice to set aside a portion of a property’s monthly income as capital expenditure reserves to cover unforeseen costs.
The exact amount varies depending on the property type and size, but a multifamily apartment building should budget $250 per unit per year.
The Benefit of Underwriting for Borrowers, Lenders, and Investors
Underwriting is essential because it helps to safeguard the lender, the investor, and the borrower. The underwriter can help guarantee that a loan is made with the maximum protection for all parties by carefully assessing the risks associated with the loan.
Additionally, this procedure can assist in reducing the risk of lending-related fraud and other issues. Commercial real estate underwriting is a crucial step in the loan process that helps to protect investors, lenders, and borrowers.
What Do Commercial Real Estate Underwriters Do?
The underwriter researches to guarantee that applicants provide truthful answers and that their financial situation is authentic. In real estate deals, underwriters check to see if the property’s sale price aligns with its estimated worth.
The applicant’s creditworthiness will be evaluated by the underwriter, who will also give them a rating. This credit score is calculated by the major credit agencies and considers the applicant’s employment record, financial capacity, and ability to repay the loan.
Conclusion
The underwriting process for commercial real estate is a comprehensive and essential phase in the lending process. Borrowers can ensure that they completely understand what to anticipate and how to receive the best conditions for their loan by consulting with an experienced lender. You can always find the best lenders on Finance Lobby.
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