CRE underwriting. 10 practical tips

Underwriting a commercial real estate deal is essential for weighing the upsides and downsides linked to property investment, from the purchase price and the down payment to monthly rent collections, expenses, and potential income. A thorough assessment can unlock the door to prosperous investment outcomes, whether you’re going for a multi-family unit or any other real estate asset. Slip-ups during this phase could hit your wallet hard.

Here are ten tips to steer you through CRE underwriting smoothly, paving the way for savvy investments and the consequences of failing to follow these tips with concrete examples and data.

First, let’s define what underwriting is. Watch the CEO of Cash Flow Portal, Perry Zheng, explain underwriting in simple terms:

1. Verify the numbers

Solid underwriting is built on precise financial information. Inaccurate figures can steer you off course, resulting in misguided investment choices and hefty financial setbacks.

How to verify the numbers:

• Request detailed financial statements: Ask for the property’s profit and loss statements, rent rolls, and tax returns from the past few years.
• If at all possible, cross-check data with bank statements: Verify the reported income and expenses with actual bank statements if you can obtain them (sometimes might not be possible).
• Engage a professional auditor: Hire a certified accountant or auditor to review and validate the financial documents.

For example, if you fail to verify the seller’s income and expense statements, you might purchase a multi-family property expecting an annual revenue of $120,000 based on the seller’s statement. After closing the deal, you find the actual income is only $90,000 due to exaggerated rent rolls and unaccounted vacancies.

This $30,000 shortfall dramatically affects your return on investment, reducing your projected cash flow and overall profitability. If your expected net operating income (NOI) was $60,000 based on the $120,000 revenue, it might now be only $30,000, cutting your profit margin in half and potentially making it difficult to cover mortgage payments and other expenses.

In this video, Perry Zheng explains the levels of underwriting and how to analyze some numbers:

2. Conduct thorough market research

Understanding the market helps in making realistic revenue projections and identifying potential risks.

How to conduct market research when underwriting a property:

• Analyze comparable properties (comps): Look at recently sold and rented properties in the area with similar features to gauge market value and rental rates.
• Study local economic trends: Review reports from sources like CoStar, Zillow, and local government data to understand economic and demographic trends.
• Consult with local real estate experts: Talk to local realtors, property managers, and appraisers to get insights into the market conditions.

Lack of market research when underwriting a deal might lead to an overestimation of rental income and make you invest in a property in a declining neighborhood. This could result in a much lower occupancy rate than projected, leading to significant cash flow issues and potential financial losses.

For instance, if you expected to rent units at $1,200 per month based on outdated or inaccurate market data, but the market supports only $900 per month, your annual revenue could be $36,000 less than expected ($300 shortfall per unit x 12 units x 12 months). This shortfall affects your ability to service debt, pay operating expenses, and achieve your targeted return.

3. Assess the property condition

Understanding the condition of the property is key to making precise predictions regarding repair and upkeep expenses.

How to assess the property condition:

• Hire a professional inspector: Engage a licensed property inspector to conduct a thorough inspection of the property.
• Review past maintenance records: Ask for and review any maintenance and repair records to understand the property’s upkeep history.
• Conduct a walkthrough: Personally visit the property to check for visible issues and get a feel for the overall condition.

If you fail to assess the property’s condition, you may discover major structural issues or outdated systems after purchase. These unexpected repairs could cost you an additional $50,000, severely impacting your budget and overall investment returns. For example, unexpected roof repairs, HVAC replacements, or plumbing issues can increase your initial expenditure, reducing your NOI and thus lowering your return on investment. If your expected ROI was 8% with projected expenses, unforeseen additional repairs could reduce it to 5%, making the investment less attractive.

4. Evaluate the cap rate

The cap rate plays a key role when underwriting a deal. The cap rate helps evaluate potential ROI and property worth. To calculate the cap rate, divide the property’s net operating income by its market value or acquisition cost. Investors leverage the cap rate to assess various investment options and make decisions based on returns and risks alike.

How to evaluate the cap rate:

• Use market-specific data: Obtain cap rate data specific to the property’s location and asset class from sources like CoStar and Real Capital Analytics.
• Compare with similar properties: Look at cap rates of recently sold comparable properties in the same market.
• Adjust for property-specific factors: Consider the property’s condition, tenant quality, and lease structure when evaluating the cap rate.

What happens if you fail to evaluate the cap rate?

You might overpay for a property with a cap rate of 4%, thinking it’s a good deal. Later, you find out the average cap rate in the area is 6%, meaning you overpaid and will have a lower-than-expected return on investment.

For instance, if you purchase a property for $2,000,000 expecting a 4% cap rate with an NOI of $80,000, discovering the market cap rate is 6% means the property is worth only $1,333,333 at that income level. This miscalculation can lead to an overpayment of $666,667, reducing your potential ROI and making it difficult to sell the property at a profit in the future.

5. Create a detailed CapEx budget

A detailed CapEx (Capital expenditures) budget helps in planning for property improvements and avoiding unexpected expenses. It directly impacts the property’s long-term financial health and potential returns. Capital expenditures refer to large-scale investments made in a property to maintain or enhance its value over the long term. Such expenditures include renovations, upgrades, major repairs, or equipment purchases that extend the property’s useful life or increase its income-generating potential.

How to create a detailed CapEx budget:

• Conduct a thorough inspection: Identify all necessary repairs and upgrades during the property inspection. Hire qualified inspectors, such as structural engineers, roofing contractors, etc. to conduct a comprehensive property inspection. They will help you identify all necessary repairs and upgrades upfront and provide you with a clear understanding of potential costs and help you avoid surprises post-acquisition
• Obtain multiple contractor quotes: Get detailed quotes from several contractors to ensure competitive pricing.
• Include contingencies: Add a contingency amount (usually 10-15%) to cover unforeseen expenses.

Without a detailed CapEx budget, you might underestimate renovation costs. For example, you might budget $50,000 for upgrades that cost $80,000. This $30,000 shortfall can strain your finances and delay project completion. Let’s say, you planned for a 10% ROI based on the $50,000 budget, the additional $30,000 expense reduces your cash reserves, increases your overall project costs, and may lower your ROI to 6-7%, affecting your investment’s financial viability, attractiveness to future investors or buyers, and your reputation as a GP.

6. Plan for a conservative exit strategy

In the end, a conservative exit plan is all about safeguarding investors from financial setbacks by setting their expectations in line with actual market situations. The main goal is to make sure that the investment stays solid and profitable in the long run, even if the property doesn’t increase in value as expected initially. Being conservative about future market conditions can prevent the overestimation of future property values.

How to plan for a conservative exit strategy:

• Analyze historical data: Study historical market performance during economic downturns to make conservative projections. You can start by accessing local real estate boards like the National Association of Realtors (NAR) or local MLS databases for property sales data over several economic cycles. Government websites such as the U.S. Census Bureau provide demographic trends and economic indicators like employment rates and income growth, crucial for understanding market stability. Commercial real estate data platforms such as CoStar and Real Capital Analytics offer detailed historical transaction data and market reports.
• Use a higher exit cap rate: Apply a higher cap rate for exit projections to account for potential market fluctuations.
• Prepare multiple scenarios: Create best-case, worst-case, and most likely scenarios to understand potential outcomes.

Why is a conservative exit strategy important?

For example, you might project a 4% cap rate at exit, only to find the market has shifted, and you must sell at a 6% cap rate. This miscalculation can result in a much lower sale price and reduced profits. Say, you expected to sell a property with an NOI of $100,000 at a 4% cap rate for $2,500,000 but must sell at a 6% cap rate. The property value drops to $1,666,667. As a result, you may experience a $833,333 loss in potential sale proceeds, dramatically affecting your overall investment return.

7. Understand financing options

Real estate investors have several financing options including traditional bank loans with competitive rates and longer terms, private money lenders offering faster approvals with higher rates, and seller financing for more flexible terms directly with the property seller. Each option varies in eligibility, interest rates, and repayment terms. Therefore you need to evaluate them based on your investment goals and financial circumstances.

How to understand financing options:

• Consult with multiple lenders: Speak with various banks and financial institutions to understand their loan terms and conditions.
• Analyze loan structures: Compare fixed-rate versus adjustable-rate mortgages and their long-term impact on cash flow.
• Evaluate prepayment penalties and fees: Understand any prepayment penalties, closing costs, and other fees associated with the loan.

If you fail to understand financing options, you might choose an adjustable-rate mortgage without realizing the potential for significant rate increases. This can lead to higher-than-expected monthly payments and cash flow problems. For example, if your initial mortgage payment is $5,000 per month, but interest rate adjustments increase it to $7,000 per month, the additional $24,000 per year in payments can erode your NOI and lower your overall ROI, potentially making the investment unprofitable.

8. Consider economic and physical occupancy

Talking about economic occupancy, we’re looking at the real rental money coming in after considering empty units. Whereas physical occupancy is all about the percentage of units that are currently rented out. Understanding these concepts is key to predicting rental earnings correctly and evaluating how well the property is doing financially.

How to consider economic and physical occupancy:

• Review current leases: Examine all active leases to verify rent amounts and lease terms.
• Check payment histories: Look at tenant payment histories to identify non-paying tenants or frequent late payments.
• Evaluate vacancy trends: Study historical vacancy rates for the property and similar properties in the area.

If you fail to distinguish between economic and physical occupancy, you might assume a property with 90% physical occupancy is performing well. However, if only 80% of the tenants are paying rent, your actual income will be significantly lower, affecting your cash flow and profitability. For example, if the projected annual rental income based on physical occupancy is $180,000 (90% of $200,000 potential income), but the actual collected income is $160,000 (80% of $200,000), you lose $20,000 annually. This discrepancy can affect your debt service coverage ratio, making it harder to meet loan requirements and potentially risking foreclosure.

9. Use Cash Flow Portal for efficient underwriting

Using specialized software can speed up the underwriting process and improve accuracy. The software not only saves time but also lowers the likelihood of errors in making decisions. For example, automating rent roll analysis and expense projections can save hours of manual work and reduce errors. Neglecting to use such software could result in miscalculations, like underestimating expenses or overestimating rental income, leading to lower returns.

Watch this video to learn more or read the instructions below:

How to use Cash Flow Portal to underwrite real estate deals:

1. Start by entering details for the property, such as the purchase price and address. Input the purchase price, for instance, $32 million, and upload the Rent Roll. The software will automatically parse the data, showing minimum, maximum, average, and percentile rental rates, which helps identify vacant units and ensures accurate income projections.
2. Next, review and pivot the unit types in the Unit Mix section to calculate both market rent and performance rent. Utilize the highest figures from the pivot table for precise underwriting calculations. Then, proceed to the Closing Costs tab, entering details such as mortgage fees and origination fees to ensure comprehensive financial planning.
3. In the CapEx section, outline the business plan by detailing expenditures like interior upgrades, renovations per unit, and fixed costs for the leasing office and landscaping. Adjust these figures dynamically to reflect real-time changes in projected expenditures.
4. Move to the Finance section and designate portions of rehab costs as financed rehab to illustrate flexible financial planning. Adjust interest rates to optimize cash flow projections and observe the impact on the Internal Rate of Return (IRR) for a balanced financial model. The software integrates future income projections based on historical data from T12 forms, distinguishing between total income and additional income sources like past-due recoveries.
5. Finally, automate expense management by categorizing T12 expenses and projecting them forward. This ensures accurate financial modeling, including detailed breakdowns for contract services and utilities, streamlining expense projections for better decision-making.

10. Prepare for worst-case scenarios

If you don’t plan for the worst situations, you might struggle to handle surprise costs such as big repairs or long periods without tenants. This could put a strain on your finances and affect your ROI. For example, lacking a backup fund could mean trouble when unexpected expenses like fixing the roof or dealing with vacancies pop up. It can lead to cash flow issues or even losing your property if you can’t keep up with mortgage payments. Also, having insufficient insurance coverage could leave you open to major financial setbacks in cases of fires or legal claims.

How to prepare for worst-case scenarios:

• Create a contingency fund: Set aside funds to cover unexpected expenses and vacancies; for example, having a reserve of $50,000 can help manage sudden repair costs or periods of lower occupancy without disrupting cash flow.
• Stress-test your financial model: Run scenarios with higher vacancy rates, lower rental income, and increased expenses to see how the property performs under adverse conditions. For instance, simulate a 20% vacancy rate and a 10% increase in maintenance costs to ensure the investment remains viable.
• Maintain adequate insurance coverage: Ensure the property is fully insured against potential risks such as natural disasters, liability, and property damage. This might involve purchasing flood insurance for a property in a flood-prone area to avoid significant financial loss in case of a natural disaster.