When investing in real estate, commercial is where it's at. Guaranteed returns from income and capital appreciation? Yes please!
But you already knew that. What you probably didn't know is that in order to be involved in commercial real estate investing, you need to understand and be involved in the commercial real estate underwriting process. So with that said, let's get you up to speed.
What is underwriting?
Underwriting is the process lenders use to evaluate the honesty, creditworthiness, and risk of a potential customer. It pulls back the curtain on everything a lender needs to know about you as a loan applicant and about the property you are looking to invest in.
Underwriters themselves act as a human lie detector test that determine if an applicant or property represents themselves truthfully, and looks to gain a sufficient understanding of their finances. Research into applicant's credit scores, employment history, and property appraisal determines the insurance premiums and fair borrowing rates. Underwriters' fact checking and due diligence also determine ultimately if an investment — in you and in the property — is worth the risk.
How Underwriting is Used in Commercial Real Estate
From a commercial real estate lens, underwriting provides a financial projection of a property's future cash flow. As mentioned before, this pre-purchase stage scrutinizes both the borrower and the property they are looking to borrow for. In addition to the underwriters request for a property appraisal, they will also ensure no one else is on the title and whether or not the location of the property is susceptible to floods, fires, or other natural disasters — all variables that would raise lending risk.
Underwriting an Existing Building
Investing in a current commercial building allows you access to previous property performance and get a better estimate of how it could perform under your care. According to AQUILA Commercial Real Estate Firm and Learning Center, you are blessed with telling data about possible vacancy rates and tenant behavior including:
- the lease expirations of the current tenants during the hold period
- the renewal probability for the tenants with leases expiring
- the projected market rents for the building as the in-place leases expire
- the expected costs (tenant improvements, leasing commissions and downtime) to renew the existing tenant or get the space released
Underwriting a Development
A majority of commercial real estate underwriting looks at an existing property's history. But what if there is no property history to look at?
The underwriting process of a development is the same as for an existing building, just more challenging. You are still projecting the building's cash flow over a specified time horizon, you just have to include the costs and timeline of the construction period. Developments require upfront money well before any income is generated, and time to get the site permitted to build on, built, and permitted to lease out. Even if construction is able to follow the planned budget and timeline, it is still hard to accurately underwrite how long the building could remain vacant, despite pre-leasing being an option for tenants.
The Five Most Important Underwriting Inputs
While there is a lot of research and variables that go into the underwriting process, there are five that stand above the rest. Research into these five inputs allow you and your lender to make a series of assumptions about how your future property will perform. The success or failure of your potential real estate investment relies on the accuracy of these assumptions, so it is critical that they stay on the conservative side.
Entry and Exit Cap Rate
The biggest indicators of investment return metrics are the property's original purchase and final sale price.
The entry cap rate is found by dividing the the property's Year 1 Net Operating Income (total property revenue minus the operating expenses) by the purchase price. That number should then be compared to other properties in the area to ensure that it is a reasonable number. The property entry cap also provides a reference point for what the property could sell for at the end of the investment period — or better known as the exit cap rate. Because the exit cap rate estimates what the total return for an investment will be, investors should look for properties that will have a 2% - 3% increase in cap rate each year of the investment holding period. This is to account for the uncertainty in future market conditions and to make sure that the ending sale price is one you are happy with.
While the dream is to have a nonstop income stream from your rental properties, the reality is that there will be holding periods — especially in multi-family units — where your property will be empty for whatever reason (primarily tenant turnover or repairs and renovations). To account for this, the underwriting model needs to factor in the cost of vacancy to provide a more realistic forecast of future cash flow.
The estimated vacancy rate will vary depending on economic conditions, property type, tenant quality, supply and demand, and location, but a general rule of thumb is to have a vacancy allowance of 5% - 10% of your gross rental income. Don't be alarmed if your vacancy rate starts off higher in the property's initial stages; it should stabilize over time to that five to ten percent. If not, it might be time to implement an exit strategy.
Rent and Expense Growth
Something that we can always count on: Inflation.
Inflation is influenced by many factors — economic conditions, property location, seasonality, supply and demand, etc. — and when it comes to owning commercial real estate, it tends to work in your favor. As the cost of goods, services, and living increases, so does the amount that can be charged for rent and utilities; however, unfortunately so does the cost of operating expenses. Some operating expenses can be easier to forecast than others. For example landscaping and maintenance can run on multi-year contracts, but property taxes and insurance rates cannot. Generally, both the income growth percentage and the expense growth percentage can be individually estimated at 2% - 3% annually.
The terms of your commercial real estate loan can fluctuate over a holding period, so knowing all the jargon that goes along with investment real estate will never hurt. Not knowing will though. Being a financial wordsmith comes in handy when accurately mapping out the cost of debt and calculating required monthly payments. Understanding loan inputs like interest rate, amortization, term, loan to value ratio (LTV), and debt service ratio (DSCR) will help you do that.
Capital Expenditures Reserves
Simply put, capital expenditure reserves is putting aside a certain amount of money from the property's monthly income that is meant to pay for any future expenses. This accruing savings and nest egg would cover any major repairs, renovations, or improvements to keep the property's physical condition in tip-top shape. The exact amount you want to put away varies by property type and size, but a good rule of thumb — we love these — is $250 per unit, per year for a multi-family apartment building.
Underwriting is just one of the many necessary steps to complete before getting started in real estate investing. Find out what happens after the commercial real estate underwriting process and how Flagship Bank can help.
Download our complete Investment Real Estate Guide today.