What does it really mean to underwrite a real estate deal?
In real estate, underwriting is defined as: When an individual or business entity seeks funding for a real estate project or purchase, the loan request is scrutinized by an underwriter to determine how much risk the lender is willing to accept. These types of underwriters are not to be confused with securities underwriters who work to determine the offer price of financial instruments. Real estate underwriters take into consideration both the land and the borrower. The United States Department of Housing and Urban Development (HUD) defines underwriting as “the process of analyzing a loan application to determine the amount of risk involved in making the loan; it includes a review of the potential borrower’s credit history and a judgment of the property value.” In most real estate loans, the property itself is used as collateral against the borrowed funds. Underwriters generally use a debt-service coverage ratio (DSCR) to determine if the property is able to redeem its own value. If so, the loan is a more secure proposition, and the loan request has a greater chance of being accepted. So, underwriting is really fact checking and part of the due diligence you should be doing to determine if the deal is worth pursuing. Underwriting can happen several ways and it’s the underwriter who will recommend the debt that is appropriate for the property to carry.
Approaching Underwriting
When approaching underwriting, you should be doing it, and a third-party with no ties to the deal should look at it too. For example: 1. I always underwrite my own deals. I scrutinize all of my deals. 2. I send to a third party. My advice is to send to a broker, one separate from the deal and with no knowledge of what I did in my underwriting process. 3. WCS (Worst case scenario). Underwrite to the worst possible outcome. Use this on every approach. 4. Real Estate Broker (I actually don’t place too much credence in this one because they usually don’t factor in the WCS.) In my first deal, I had no idea how to underwrite the deal. If I had, I would have never done it. That deal was a single-family home. Big mistake!
How Rea Capital Underwrites On A Deal
Here’s an example of some of the formulas, math and calculations I use when I’m doing underwriting on a deal. I look at the Gross Schedule Income, GSI. This is what rent is projected to come in. Again, this is projected so it’s not actual, so I only look at it. I study and pay attention to Effective Gross Income, EGI. This is what rent actually comes in. I always use EGI. From this number, I’ll deduct 50% for operating expenses. I know it won’t be this large of a percentage, but I’m working in the WCS (worst case scenario) zone. The resulting number is the Net Operating Income, NOI. I then take the NOI and divide it by the asking price, or the price I think I can acquire the property at and that number is my CAP rate. A CAP rate is short for Capitalization rate. This term is defined as a rate that helps in evaluating a real estate investment. Cap rate equals NOI/Current market value (sales price) of the asset. So, the CAP rate shows the potential rate of return on the real estate investment. On brand-new property, your EGI won’t exist and you will have to project what your rent will be once the property stabilizes. That means once it ramps up and occupancy increases. Another factor to use in your calculations is projecting how much your rent income will grow and how much your expenses will grow as you hold the property over a ten-year period. I use ten years because I know I typically hold a property that long if not longer. I calculate that rent will increase two percent each year while expenses will grow at three percent. That’s fine that expenses grow one percentage faster because you have to remember that your operating expenses are only half of the total of income. So, two percent on one-hundred percent will always be more than three percent of fifty percent. Or course, you have to pay attention and know many other factors like interest only compared to principle and interest loans. Calculating how much your tenants pay down your debt over and over again and more.
Conclusion
My advice is to not be afraid of the bigger deals. Small deals don’t pay enough. The largest portion of billionaires in this country have their money invested in real estate. Shop, research and walk your potential deals.
