Discover why it's a great tool for evaluating risk and return.
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Whether you're a shiny new commercial property investor or a seasoned pro, 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, savvy commercial property investors are turning to underwriting.
Underwriting is used by insurers and mortgage lenders. Essentially, it’s the process of evaluating the risk and profitability of something – such as a person, vehicle or building – in order to insure or lend money. From a commercial property investor’s point of view, the underwriting process is similar in that it’s all about evaluating risk.
Commercial property underwriting can help you make smart decisions by enabling you to:
Determine if the proposed business plan is viable
The term ‘underwriting’ itself can refer to a number of things. For commercial property,
Ross Pemmerl, vice president of underwriting at Boston-based UC Funds, describes it as: “The process of carrying out full due diligence of a prospective transaction. To put it another way, it means 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.” Ultimately, underwriting is a way to determine the overall viability of a proposed business plan, identify what potential risks exist, and anticipate the returns.
Decide if the deal is worth pursuing
As a commercial property 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 such as a property's net operating income and value are very helpful to commercial 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 new 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.
Obtain more precise projections
Underwriting can be time intensive and requires effort, but with the knowledge you'll gain, you can make more informed decisions. Be prepared to put in the work, advises 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.” 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.”
For a successful underwriting process follow these steps:
The first step is to work with a professional underwriter and/or commercial property 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 US 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/organisational structure.
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 commercial property opportunities are highly coveted and highly competitive,” advises Pemmerl. “An experienced underwriter should be able to provide feedback on a prospective transaction within 24 to 48 hours of reviewing the opportunity.”
- 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. Pemmerl says: “We’ll visit the asset, analyse the market and tour the asset's primary competitors. We’ll review all of the pertinent source documents (bank statements, tenant leases, utility bills, tax bills, service agreements, construction contracts etc), and we’ll engage third-party reports including appraisals, engineering reports, and environmental reports.”
- 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 property 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.
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