A Review of Real Estate Underwriting Principles
A crucial component of any asset’s acquisition is the underwriting process. Savvy investors might rely on a mixture of professional experience, extensive networking, and their sixth sense to direct them to investment opportunities, but it is during the underwriting process that it becomes clear whether a property is going to meet the sponsor’s standards for investment.
Underwriting is complicated and not easy; fortunately, investors can follow clear processes to mitigate risk most effectively. These processes require that investors be patient, thorough, and open-minded to the idea that their understanding of an asset and its accompanying market is incomplete.
This article will discuss two primary topics: the principles of underwriting and how these underwriting principles help dictate an investment strategy.
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What is Underwriting in Commercial Real Estate Acquisitions?
In commercial real estate acquisitions, underwriting is the research and analysis of an asset that predicts its potential risk, likely returns, the price it should be bought for, and the price at which an investor can exit from the investment in a future sale.
Underwriting takes a multitude of factors into account to calculate the likely cash flow for a given property. To make this prediction, it is necessary to evaluate numerous components.
Net Operating Income (NOI)
The NOI is calculated by subtracting all expenses (including property taxes, but not debt service expenses) from the total annual income derived from a property. Accurately estimating an asset’s NOI is crucial in any underwriting process.
The capitalization rate, ‘cap rate’, is used to measure the relationship between the price of an asset and the amount of income it delivers to investors. Known as ‘yield’ in the corporate world, the cap rate is calculated by dividing the net operating income by the price paid for the asset or the total value of the asset.
Cap rates vary substantially over time, as shown in the graph below and generally are positively correlated with the risk-free rate i.e. that of 10-year Treasury bills.
In addition to variations based on asset class as shown in the graph above, cap rates differ according to location, quality of the asset, age of the asset and myriad other factors. They are used to predict values upon exit of an investment and the cap rate is used in combination with other value metrics as part of the overall underwriting process pre-acquisition.
Price Per Unit
In asset types with more than one potential lease on a property such as in multifamily assets, it can be helpful to calculate what the price breaks down to per unit. In office or industrial, the price per square foot of the overall project is important. When using price per unit or price per square foot, a buyer has a benchmark for investors to compare one property against another and can help them understand what the required rent per lessee should be, again relative to other similar properties.
If at first glance the property’s price per unit or price per square foot is out of proportion with surrounding comparable assets, or the necessary rents to sustain that price are too high for market conditions, the building might be rejected as an acquisition candidate before too much additional due diligence effort is expended.
No asset can be considered without looking at the history of taxes due on a property and the likely increase in taxes if the property value appreciates due to market factors or improvements to the property. Furthermore, inexperienced investors can fail to recognize that property taxes, as one of the largest cost line items, can vary significantly from market to market and, in many cases, are reset upon change of ownership.
Failing to fully and accurately research and underwrite change of ownership implications on property taxes, or other implications of a sale or capital expenditure program can severely impact a property’s NOI and cause projections to fall short.
Rent rolls allow potential buyers to see a roster of tenants as well as their payment history. Rent rolls are crucial for determining the actual NOI and cap rate. They typically include a list of all tenants in the building, their lease commencement date, termination date, amount of rent, and any concessions – meaning free rent or other discounts.
A full underwriting of a target acquisition will include examination of the underlying documents that substantiate the rent roll. In most multifamily assets the same standard contract is used by the ownership for each tenant, however variations do exist, and it is important that a buyer understand what their commitment will be to all tenants should a sale conclude successfully.
In multi-tenant office properties there are countless ways a lease can be written with different terms, conditions, expiration periods, rents and other variables that all need to be considered and incorporated into the underwriting of the asset.
Rent and Sales Comps
Proper underwriting demands a thorough understanding of the local market in terms of the average rental rate and average sales price for comparable properties in the area – more commonly known as ‘comps’. There is little value in acquiring an asset and underwriting to a high rental rate if the local comps do not support such high rents. Similarly, by looking at various other indicators among the comps, such as price per unit, sales cap rates, price per foot and other metrics, investors can position an asset in the context of the surrounding market both as a gut-check that the basic metrics are in tune with market conditions, as well as to reveal opportunities for adding value and driving profits.
Location plays a huge part in underwriting and is the variable that allows underwriters to evaluate the following factors:
- Construction drivers
- Employment drivers
- Overall economic drivers
- Comparable incomes of residents in the area
- School ratings
- Crime rate
By looking at these factors, it becomes possible for an underwriter to accurately assess the value by measuring the desired asset against comps. If a multifamily comparable and the desired asset are both valued at $20 million, but the comp is in an area with lower school ratings and a higher crime rate, it may be reasonable to assume that the target asset will command higher rents than the comp.
This assumes that the market in question is housing families with children, a demographic for which crime rates and school ratings would be important. The same concepts apply when considering the main drivers of employment and construction.
What Are the Key Drivers of Income and Expenses?
While the individual components of the underwriting process are important, there is often more than meets the eye. Past management of the subject property does not necessarily represent the best management strategies, and there are specific points that investors should review before concluding the initial underwriting process and creating a pro-forma.
Certainly, looking for prior management failures and inadequacies can reveal value-add opportunities and indicators for such opportunities can come from unexpected places. For example, an in-place management team may be content with having a long waiting list for units, but this could indicate rents are below market and could be raised to ensure a healthy 5% vacancy rate is reached and the waiting list pared down to cover predicted turnover rates.
Here are some aspects sponsors should look at before moving into determining what strategy is best for a particular property.
Rent Growth Trends
Checking the rent and sales trends over prior months and years is crucial for the underwriting process that should be factored into the proforma. Investors need to look into the historical trends and predict if the subject asset is on the upswing or on the verge of a downturn. Failure to do so could result in an acquisition that fails to perform as predicted in the underwriting process.
In multifamily developments, cleaning fees, pet fees, parking fees, laundry, storage fees, late fees, and early termination fees are all examples of ancillary income that current ownership may or may not be taking advantage of. Ancillary income is a great way to generate more income from an asset that it was not producing prior to acquisition.
The diagram above shows the range of different kinds of ancillary income that can be generated from an asset. These vary according to the location of an asset and the feedback the local management team provides regarding what the market will want and whether tenants will pay extra rent .
Vacancy rates can indicate a weak market, the lack of initiative of the current owners, or, as suggested above, too low a vacancy rate and high a wait list can indicate management complacency and be a good indicator of opportunity. The initial underwriting process should reveal if the subject property’s vacancy rates are on par with the market, if they result from the property delivering poor value to consumers, or if the current management or marketing is simply ineffective at getting the message out to potential tenants.
The graph above shows how vacancy rates tend to rise slightly during recessions and diminish during strong economic times. There are many reasons for this counterintuitive indicator because, while people always need somewhere to live, where they choose to live tends to shift during difficult economic times. For example, during recessions, friends and family members may move in together reducing the demand overall for individual units by increasing unit occupancy levels as people try to save on expenses.
This graph illustrates how location also has an impact on vacancy rates. As the US economy pulled out of the 2008-2010 recession, vacancy rates started falling but three were variations, albeit subtle, depending on location. Analyzing these variations in micro-market areas within different cities form an important part of the overall underwriting process.
Bad debt, late payments, and failure to pay rent at all are all reasons the underwriting process looks carefully at the creditworthiness of the tenant base. While the best time to get a bad tenant out of a property is before they are rented a unit, a buyer inherits the in-situ tenant base and so examining the credit history of tenants and the looking at the history of bad debt – late payments and missed payments – is an important part of the underwriting process.
Maintenance, Turnover, and Payroll
Several specific expenditures are important parts of the underwriting process when assessing a property, including, but not limited to:
- Pool Maintenance
- Turnover expenses (repainting, cleaning)
During the due diligence phase pre-acquisition, all cost line items are examined for historical trends. Higher than normal expenditures might suggest something is wrong with the asset and needs additional maintenance or possibly even replacement, or it may indicate that the management team is struggling to stay on top of a problem. Similarly, if expenditures are lower than would normally be expected, this may indicate neglect.
The Real Estate Pro-forma
Using the income and expense data from a property, a pro-forma can be created. Real estate pro-formas are detailed financial assessments. They provide line-by-line estimates based on actual income and expense data, or projections based on potential changes to revenues and expenses.
During the underwriting process, the pro-forma acts as a projection of future cash flows, allowing an investor to adjust the numbers and see how changes to the business model may affect the NOI. This is especially significant for value-add properties, as it will directly influence decision-making in regard to the viability of a project.
An accurate pro-forma gives the investor a chance to experiment with how different decisions could impact the cash flow of a property. Based on the extent of improvements to be done, adjustments can be made to the pro-forma to reflect estimated increases in the rental price, reductions in operating expenses, and other value changes.
In this way, the real estate pro-forma makes it possible to compare the future potential of multiple properties against each other and against other types of investment assets. An investor can make reasonable projections to analyze the long-term benefit from a real estate asset, accounting for potential income that may differ from the current NOI of the property.
Underwriting, Pro-forma, Market Research
The underwriting process cannot be considered complete without the inclusion of pro-forma analysis and thorough market research. These two aspects are essential to both data collection and review. Market research helps on both sides of the process, as it provides insight on properties based on data like sales/rental comps while also giving investors a window into potential opportunities in an investment deal.
While the initial underwriting processes provide the data that populates a property’s pro-forma report, market research data will guide adjustments made for future potential income projections. Market reports may reveal whether a property is under or over-valued, both of which can affect the future earning potential.
Market research should be commissioned in the initial phase of underwriting so that the data is available throughout the process to guide decision-making.
How Do Market Studies Impact Underwriting?
Because of the highly specific nature of real estate investments, investors need to thoroughly understand the market they wish to enter. Nothing can be assumed about the market conditions surrounding the property being inspected.
Through a market study, an investor will get details about:
- Economic conditions on a county, city, and national level
- Obstacles to real estate investment in the area
- Current and projected demand in the specified real estate sector
- Area population demographics
- Local geography, climate, and the physical environment
- Ongoing or proposed investment projects in the area that may affect valuations
- Comparable properties (age, location, construction, condition, layout, and other factors).
Details about comparable properties are especially useful, as they can assist an investor in confirming the valuation of a property. The property can be evaluated in its current context to understand whether or not it is actually a good investment.
A thorough market study gives investors a snapshot of what conditions are like on the ground. Even without visiting the property, the investor should be able to glean enough information from the market study to get a solid idea of what the area is like and how the property fits into its locality.
Conducting a Market Study? Utilize Local Property Managers and Leasing Agents
The greatest asset to a market study is a local expert. It is helpful to enlist the services of a commercial real estate agency or property manager with both a strong local presence in the target area and a specialization in the property type the investor is seeking.
Local knowledge goes a long way in understanding the viability of a proposed project. A local commercial real estate agency has the advantage of existing industry connections, experience negotiating in the specific market, and familiarity with ongoing and historical trends that might come into play. This is often the case if the recruited agency has specialized knowledge in the real estate sector the investor is searching for and a portfolio of relevant past experience to showcase their skill.
Some level of nuance is required to make accurate market observations. An experienced local commercial real estate agency has the benefit of both knowledge and personal experience to guide their data analysis and interpretation. Less time will be wasted in the data collection process, as they may already have detailed information related to market movement, recent sales, and more. By tapping into this existing knowledge base, investors can get more reliable data that fuels better decision-making.
How Does Underwriting Guide Real Estate Investing?
The entire underwriting process is designed to verify assumptions made by the acquisition team during the initial screening of an asset and to determine whether the investment thesis presented is deliverable. At Rising we focus on finding assets that will benefit from capital expenditures post acquisition to add value to the property. This strategy is aptly called ‘value-add,’ but there are four different strategic approaches a sponsor will consider when looking at any specific asset and deciding which to use for any given property will be determined by the requirements of the institutional investor partner.
To be clear, there are many different ways sponsors can formulate their investment strategy. For example, we may sometimes work with one institutional investor for a specific asset, and in some cases a handful of institutions or family offices on a single deal. Each will have a different investment strategy and we will tailor our approach and recommendations accordingly.
Typically, due to the amount of capital they invest in single assets, institutional investors will largely drive the approach taken by the sponsor in identifying opportunities. For example, a single large investor may be deploying some very low risk capital that requires a low-risk, bond like approach to finding a suitable acquisition. Another institutional investor may be utilizing capital for which they need to see significant capital appreciation and so in this situation the sponsor will need to identify assets that require a different investment approach, such as value-add or opportunistic, and that offer higher risk, higher return characteristics.
The first phase of underwriting any acquisition is in establishing whether an individual asset can deliver to the investment thesis we are looking for. Once that is determined, the detailed underwriting process can proceed in earnest.
The diagram below shows the various types of strategy that can be applied to a real estate asset along with the risk-return profile.
Generally speaking, core properties are low risk investments that are ideal for investors with lower risk tolerance.
Core properties are income generating investments from day one. They are roughly equivalent to bonds in that the returns are lower than those offered by many other assets, but the work required to generate income is also proportionately low, making a core property essentially a passive investment.
An example of a core investment property is a 30-year industrial leaseback with a high credit commercial tenant, or a downtown skyrise office building with low vacancy, high credit tenants, and long leases.
While core plus properties are still low-medium risk, investors will likely need to take on a more active role to generate the highest returns. These properties are generally good quality, well occupied, and have positive cash flow already, but with room to improve income generation. Investors are likely to leverage anywhere less than 60% of the acquisition cost.
To be considered core plus, the property must not require significant renovations or reconstruction to increase cash flows. There should be relatively predictable ways to increase the property’s income through basic renovations or other measures to attract higher paying tenants.
An example of a core plus property is an office building with market average vacancy rates, some high credit clients with longer leases, and other under-paying tenants with leases expiring in the shorter term. These assets have the potential for being core properties with upgrades to lobbies, the addition of amenities, new elevators, refreshed lighting systems in common areas, and other similar renovations that are more superficial than structural.
With value-add properties, investors are looking for opportunities to generate higher returns through making significant upgrades to the property. The tradeoff is a higher risk investment that will likely require more work on the sponsor side to deliver a successful result.
If these properties are generating positive cash flow already, it is likely to be far lower than the market average on comparable buildings. Value-add properties tend to have high vacancy rates, deferred maintenance, outdated features, and/or poor management.
Before investing in a value-add property, investors must thoroughly analyze the projected improvements are going to be sufficient to generate sufficient income to pay for themselves within a reasonable investment period. It is easy to make mistakes in value-add developments by underestimating the cost of improvements, the time it will take to complete them, or by missing crucial due diligence items. Discovering an asbestos problem, for example, once work commences that was not uncovered during due diligence can prove a very costly addition to a project’s overall budget as well as having a negative impact on the timeline.
What Are Ways to Add Value to an Investment Property?
Anything that either allows for an increase in revenues or reduces operational expenses is considered adding value to an investment property. This is typically achieved by matching market rates, performing necessary renovations, or modernizing a building.
The theory with a value-add property is that are opportunities to increase the profitability of the investment through some actions by the investor. In some cases, that may involve re-negotiating renewal contracts to bring tenants up to current market rental rates. In other cases, it may involve significant renovations to the property to make it operate more efficiently or to attract higher-paying tenants.
In multi-family developments some improvements that can add value to unit interiors include:
- New hardware (cabinet handles, drawer pulls, towel racks, doorknobs)
- Repainting walls and trim
- Replacing aging appliances (refrigerators, dishwashers)
- Installing quartz countertops
- Replacing carpets in bedrooms
- Installing plank flooring
- Replacing lighting and plumbing fixtures
- Replacing medicine cabinets and shower fixtures
- Installing NEST thermostats, electronic door locks, and other smart tech hardware
Additionally, improvements can be made to the property as a whole such as:
- New furniture for shared spaces (tables, chairs, umbrellas)
- New designs for the building exteriors
- Renovating lobby areas
- Upgrading gym, pool, or clubhouse areas
- Increasing frequency or quality of landscaping
Value is subjective, and improvements to a property only make sense if it can be determined during underwriting that rental income can be increased sufficiently to justify the cost of the improvements. In some markets, tenants desire and expect NEST thermostats; in others, this would be extraneous.
Typically, at Rising we look for an 18-24 month period to recoup the cost of any improvements through rent increases, and a 20% return on the investment. Discussions with our in-house management team will provide the insights we need to determine if these returns are feasible on an improvement line-item basis and form part of the underwriting process in deciding whether an asset is a suitable acquisition target for our investors.
How Do You Formulate a Business Plan Once All Projections are Complete?
Crafting a business plan requires that the sponsor assemble all information gathered from the underwriting process, pro-forma, due diligence, and market studies to create a concrete path for the subject property to produce the desired target returns.
If underwriting indicates where an asset is currently, and the proforma indicates where it should end up, a business plan details the specific steps that will be taken to get the asset from point A to point B.
A good business plan details:
- What drives the market currently
- How the market is expected to change
- How acquisition of the property will be financed, and the associated debt service costs
- What NOI and cap rate the subject property is expected to deliver
- What enhancements are planned for the property
- The capex and timeline for those enhancements
The business plan outlines the investment thesis and how the target results are going to be achieved and, importantly, includes a detailed timeline and related budget. Once an asset is acquired and execution of the business plan is underway, the original budget and timeline will be the roadmap for ensuring the project is going according to plan and allows management to course correct if need be.
From start to finish, the entire process of underwriting is focused on determining the viability of an investment property. It is a long and thorough process that is only done after an initial screening has narrowed down investment options.
Accuracy is the first priority of underwriting. Without accurate information, an investor cannot draw useful conclusions from the data in each report. Based on individual risk tolerance, expected ROI, and financial access, a final investment decision can be made. Upon completion of the business plan, the investor will be in a good position to minimize their risks and immediately put their ideas into action.
Chris Rising manages the day-to-day business activities of Rising, while also serving on its Investment Committee.
He received his J.D. Law, Real Estate from Loyola Law School and his B.A. in History and Political Science from Duke University.