Underwriting is the financial analysis of a property. Detailed due diligence is always done after the property goes under contract, but underwriting is done to assess the feasibility of an asset to see if it meets the basic financial criteria before the buyer submits an offer. Your broker will typically bring you an OM(offering memorandum) which is a synopsis of the financial performance and other pertinent information regarding the property.
The offering memorandum usually includes basic information of the property such as the address, parcel ID, year built, square footage, number of units, unit configuration, type of building material, roof type, etc. It also should include the rent roll(statement of current rents, security deposit, and balance sheet for all tenants), T-12(revenue and expenses for the past 12 months) and P&L(profit & loss statement) for the past 2-3 years. It also includes pictures of the exterior/interior as well as rental comps and general information of the local area.
In a perfect world, the offering memorandum should have all necessary information for the buyer, but the reality is far from it. One has to understand that the OM is created by the selling agent or broker, who is trying to sell the property for as much as possible for his/her client. It’s not that one has to assume that the seller and/or the selling agent is trying to dupe the buyer(although in some cases, this may be true), but it makes sense to do an independent analysis. In other words, trust, but verify.
A lot of the pro forma(projected) numbers are subjective, and even the existing numbers have some wiggle room. A seller’s agent can technically check all the boxes of “being honest” yet leave out a lot of critical information. He can also come up with a very lofty pro forma numbers that is not quite what the buyer had considered.
One of the common ways for fudging numbers is where the selling agent prices the asset according to the pro forma numbers. Commercial properties are priced based on the income it generates. The ratio of NOI(net operating income) vs the purchase price is termed the cap rate(capitalization rate). If the going cap rate in the area is 7%, and the NOI is $100,000(on an annual basis), then $100,000/.07 = $1,428,571, the fair market price. It is fairly common for the selling agent to price the asset based on the pro forma numbers rather than the existing numbers, especially in a seller’s market. What this means in the above example – The current rents might be $800 and that results in the NOI of $100,000, justifying the $1.43M valuation. The selling agent might try to justify a higher price by arguing that the comparable rents are higher, resulting in a higher NOI. Let’s say that the comparable rents are $950, $150 higher than the subject property. This may result in the NOI being $120,000. Based on the same 7% cap rate, $115,000/.07 = $1,714,000.
The problem with this logic is that the property is not yet generating this income. Also, in order to command the higher rent, the buyer may need to invest some money and effort in renovating the units. The seller is pretty much asking the buyer to pay the price for a property that had all the work done with new rents signed for all the units. Unfortunately, this practice is not uncommon, and if the buyer accepts the selling agent’s numbers, he/she is likely to almost always overpay.
So how does an investor perform an unbiased underwriting?
At Elevate Real Estate Investments, we adhere to strict underwriting guidelines for evaluating the financial feasibility of each deal.
With many deals to analyze, the initial underwriting utilizes some assumed metrics, and when the deal pencils out according to the rule-of-thumb, it receives more detailed scrutiny.
It starts with a comprehensive rent survey to gauge realistic rents. More than just proximity, we are well aware of the large variance in neighborhood textures across school districts, certain streets and more, so we utilize all available resources to determine accurate rental comps.
Market vacancy rate is accounted for and subtracted from the total revenue. Even in cities with low vacancy like Columbus, we account for at least 5%.
Initial expense estimation is done by assuming a conservative expense ratio according to the asset class. Expense ratio is the ratio of operating expenses compared to the total revenue.
45% expense ratio assumed for class A, 50-55% expense ratio for class B, and 60% expense ratio for class C assets.
Capex is an item often unaccounted for in underwriting. Capex refers to costs associated with replacing components like roofs, floors, HVAC, appliances, and parking lot. 5% of revenue for Class A, 7% for class B, and 10% for class C assets
Let’s go through an example.
A 30 unit building in Class C area in Columbus with the asking price of $1.4M. Going cap rate for class C in Columbus is 7% Rent survey determines the market rents to be $700.
30 X $700 = $21,000. Total annual rent = $252,000
5% vacancy = $12,600
$252,000 – $12,600 = $239,400. (gross rent)
Class C = 60% expense ratio.
$239,400 * 0.6 = $143,640 (expenses)
$239,400 – $143,640 = $95,760 (NOI)
$95,760 / .07(cap rate) = $1,368,000
You can see that the fair market value is $1.368M, pretty close to the asking price.
Once a property passes the initial screening, we obtain the current rent roll, T-12 and 2 years of P&L from the broker and construct a detailed financial model on a spreadsheet. The model is much more detailed and accurate than the rough initial estimate, and takes into account itemized historical expenses, new tax rates, and appropriate capex budget. The modeling can give us a projection for our hold period, and we can get an idea on what kind of returns to expect over the life of the investment.
Once we construct a realistic pro forma expenses and revenue, we can apply the going cap rate in the local market to calculate the max price that we can pay to make the deal profitable. This methodical process makes the decision very mathematical and unemotional. We can look at each deal objectively and make a clear go/no-go decision. Of course the underwriting assumptions have to be verified during the due diligence process once the property in under contract, but a thorough underwriting ensures that the buyer has a good idea of the asset’s feasibility before putting committing earnest money deposit and signing the purchase contract.
Ki Lee
[tags: underwriting, real estate, deal analysis, apartment investing, real estate investing, due diligence]