How Underwriting is Used in CRE
Why It's a Great Tool for Evaluating Risk and Return
Whether you're a brand new commercial real estate (CRE) investor or a seasoned professional, you want to do your due diligence before moving forward with an investment. Some of the questions you may have might be about the property's condition, its current cash flow and value, and the potential income.
To investigate all of these questions and more, CRE investors turn to underwriting. You might be familiar with the term from the perspective of a borrower, since lending institutions use underwriting to help determine loan terms. On your end, the underwriting process is similar in that it's all about evaluating risk.
Here's what you need to know about CRE underwriting.
What is Underwriting as it Relates to CRE?
The term "underwriting" itself can refer to a number of things, but for commercial real estate, it's the "process of fully 'diligencing' a prospective transaction," says Ross Pemmerl, vice president of underwriting at UC Funds, a capital solutions firm in Boston, Mass. Put another way, you must get to know the project team and understand their business plan, examine the property's current market conditions and the trajectory of that market, identify any structural needs of the asset, and drill down into the property's prospective cash flows, both in-place and upon stabilization, Pemmerl explains.
Ultimately, underwriting is a way to determine the overall viability of a proposed business plan, identify what potential risks exist, and anticipate the returns.
How is Underwriting Used?
As a commercial real estate investor, underwriting is a tool that will help you make investment decisions. It's the underwriter's job to look at all of the collective data (business plan, project team, market conditions, physical needs, etc.), and use it to come up with the asset's current and future value.
"The underwriter will be able to determine an asset's as-is value and in-place cash flow, as well as an its future cash flow and value potential," says Pemmerl.
Key figures like a property's net operating income and value are very helpful to CRE investors as they can determine whether or not a deal is worth pursuing. Some of the information underwriters may need for an existing property include the lease expiration and renewal probability of the current tenants, the projected market rents for the building as the in-place leases expire, and the expected costs to renew or replace existing tenants.
For developments, you'll have to take into account everything from construction costs to market conditions to try to make projections about future rents and cash flows.
What CRE Investors Need to Know
Underwriting can be time intensive and requires much effort, but with the knowledge you'll gain, you can make more informed decisions. Be prepared to put in the work, says Pemmerl.
"Take the time to go out and physically see the asset, talk to the tenants and the property management company, and personally tour the market to see how comparable properties are performing," he says. This will all help with the underwriting data gathering process—the more information you can gather and data points you can confirm, the more precise your overall projections will be.
As they say,"aim small, miss small," says Pemmerl. "A 2% shortfall on projected cash flows will be a lot more palatable than a 20% shortfall."
Follow These Steps for a Successful Underwriting Process
The first step is to work with a professional underwriter and/or commercial real estate broker to help you compile a checklist of items and third-party reports that are needed to perform a detailed underwriting.
For instance, Fundrise, a real estate investment platform, reports that it has more than 350 different data points in its detailed underwriting checklist, derived from site visits, a study of comparable properties, a comprehensive appraisal, a thorough budget analysis, pro-forma financial analysis, and setting up the legal/organizational structure, etc.
Once you have a team in place and a game plan, here are some other strategies to keep in mind:
- Don't delay. "One can take as little or as much time as they like underwriting a transaction, but being able to quickly and efficiently underwrite a potential transaction gives one an advantage in today's environment where quality CRE opportunities are highly coveted and highly competitive," says Pemmerl. An experienced underwriter should be able to provide feedback on a prospective transaction within 24 to 48 hours of reviewing the opportunity, he adds.
- Go in-depth. Following an initial review, expect to follow a more detailed underwriting process to verify the different components of the transaction and business plan. "We will visit the asset, analyze the market and tour the asset's primary competitors. We will review all of the pertinent source documents (bank statements, CAM reconciliations, tenant leases, delinquency reports, utility bills, tax bills, service agreements, construction contracts, title work, etc.), and we will engage third-party reports including appraisals, engineering reports, and environmental reports.," says Pemmerl.
- Have patience. A full underwriting can take anywhere from one to four weeks, depending on the property and size of the deal. Don't rush through it since a detailed report could save you from making a very expensive mistake.
Like most financial transactions, you don't want to enter into a commercial real estate investment without thoroughly vetting the opportunity. A complete underwriting process will help ensure that you are making the most informed decision about your next investment.