Are you deciding about investing in real estate but also want to reduce the risks? If yes, it is important to learn about how to underwrite real estate.In this article, we have shared all the details you want to learn about underwriting real estate.
How many times have you thought about real estate investment and imagined a house just sitting there for you to buy? Well, in reality, real estate investment is not that easy and straightforward.
In fact, real estate deals have so many different parts and details; you might find it hard to keep in track. Attributing to the constant market fluctuation and technological advancements in the industry, investors and lenders have to conduct extra due diligence on their part.
That’s where real estate underwriting comes in. This process helps both parties avoid potential risks in their passive real estate investment.
Here’s everything you need to know about how to underwrite real estate so you can consider real estate crowd investing today.
Table of Contents
What is Underwriting?
According to the US Department of Housing and Urban Development, underwriting is the detailed analysis of a loan application which helps determine the risk involved while making the loan for both parties.
Whether you’re thinking of investing in commercial real estate or entering a crowdfunding program through platforms like Fundrise, RealtyMogul, or Roofstock, underwriting is a crucial aspect in your transactions.
Before figuring out how to underwrite real estate, you should know what it is and how it works. Mainly, it is a process through which lenders determine the worth of a potential investment prospect.
Apart from the investment risk, underwriting helps point out how much premium an investor will have to pay for insurance and how to set the deal’s borrowing rates.
Believe it or not, just knowing how to underwrite real estate is not enough. Professional underwriters take lots of factors into account. Based on this information, they conclude whether insuring or lending to that person is profitable.
No real estate deal is void of risks. However, underwriting assesses whether the lender or investor can endure these risks and to what extent.
What Does an Underwriter Do?
Now that you have some idea about the extensive research and analysis it takes for commercial real estate underwriting, you know it’s a job for a professional.
An underwriter will conduct thorough research regarding a borrower’s background to ensure the investment or loan is secure. This way, you can find out whether to invest your money in the project or not.
In popular real estate crowdfunding sites, they scrutinize their borrowers and projects before they let them join the platform.
However, an underwriter will check the factors using the debt service coverage ratio. The ratio denotes a metric calculation showing the average operating income of an investment with the total loan amount.
In exact words, it will show you whether the profits made from your investment will be enough to repay the borrower’s loan.
In the end, the underwriter’s report will provide a final word stating whether the loan for acquiring a real estate investment property is secure enough to be approved or not.
How to Underwrite Real Estate
Underwriting is not confined to the real estate sector. In fact, underwriters are required wherever large sums of money are being exchanged.
Although some aspects of real estate underwriting are the same as its conventional counterparts, some factors set it apart.
Check out my free real estate property calculator to help you price out real estate more efficiently.
Here’s an overview of how real estate underwriting works.
Estimation of Cash Flow
First of all, the underwriter will check the target property’s cash flow to determine how much income it will bring. This estimation gives you a clear idea of the project’s ability to repay your investment.
To calculate the cash flow, the underwriter will consider factors such as gross income and net operating income. The better the cash flow, the more profitable the property will be.
Evaluation of Investment Returns
Another point that helps underwriters evaluate the profitability of an investment is the potential investment return.
One way they use to calculate this value is by dividing the net operating income of the property by its sale price or appraisal value.
The investment return for industrial real estate can be much different than commercial real estate.
Scrutiny of the Borrower’s History
This is the most crucial part of the underwriting process. It includes a thorough analysis of the borrower’s finances and debt history. This way, you can safely conclude whether the party you’re working with is trustworthy and reliable.
Want to walk through the real estate underwriting process? Watch this case study using my free rental property calculator.
How to Underwrite a Real Estate Deal? – Tips for Investing
Underwriting a real estate deal is essential for safe transactions between the lender and the borrower.
Whether you’re investing in a potential project through a crowdfunding platform or looking for a loan for an investment property, you have to make sure your underwriting documents are in place to get the approval.
For investors wondering how to underwrite real estate, here are some tips you can follow to make sure your property is correctly underwritten and you get the approval you need.
To make sure your underwriting process goes as smoothly as possible, you should maintain complete transparency. When trying your luck at real estate investing, keeping crucial facts from your mortgage lender is the worst mistake you can make.
Think about it; if you hide your financial situation, you can end up defaulting on the loan. This means rather than generating a passive real estate income; you might end up under a mound of debt you can’t repay.
Hire a Professional Underwriter
In the real estate business, you cannot afford to miss out on anything. That’s why, when you’ve got an eye on a potential investment, make sure to hire a professional rather than completing the job yourself.
A professional underwriter will have a firm grasp on the concepts of mortgage lending and property appraisal. Therefore, they will work to create an excellent loan-to-value ratio for your target property.
This will help you get your lender’s attention more quickly, so you can get the investment you need.
Get a Professional Appraisal
To make sure your real estate underwriting report comes out in your favor, you have to get a collateral property appraisal. Your real estate underwriting report highly depends on your collateral value.
A loan application backed by sufficient collateral property is hard to reject, especially when you’ve got the real estate. That’s because an investor will always check if your property is valuable enough to repay your loans in case you become a defaulter.
Hence, a strong collateral appraisal will strengthen your underwriting process and make you a reliable option for your lender.
Keep Essential Documents in Order
To ensure your underwriting report gets approved by your investment lender, it is crucial to have all your documentation complete and in order.
Believe it or not, investors can disapprove of a perfectly well-underwritten property because of the lack of relevant documents.
These documents verify the information that is provided in your underwriting report. Everything, including the property value details, cash flow, and income return predictions, cannot be verified if the documents are missing.
So, when filing for a real estate investment loan, keep all the essential records in order.
See Related: How to Save Money on a Tight Budget
Try to Make a Good Impression
The real estate business is based solely on risk. This means, even though the metrics and calculations are essential, it’s the trust factor that makes a deal work. So, if you want to bag a potential deal and get the funding for it, creating a good impression on the lender is important.
We’re not saying you should turn up sporting a branded suit and an expensive watch. Instead, practice upon how you can effectively impart your vision and strategy so that your lenders see the same potential in the target property as you do.
If you manage to prove yourself as an assertive character who knows what he’s doing, there’s a chance you can seal the deal even if the metrics don’t look right.
See Related: Best Fundrise Alternatives to Invest
Concentrate on the Financial Metrics
Real estate transactions are mostly a game of numbers. If you get your property professionally underwritten, check all the financial metrics involved in the report to know your property is being evaluated correctly.
For example, if your debt service coverage is 1.25 or higher, you’ll appease your underwriter. That’s because having a debt service coverage of 1.0 means you’ll only be able to pay back the loan.
However, when it goes higher than that, it means your property will generate a handsome profit as well.
Similarly, the underwriter will use your profit and loss statement and tenant rent roll to calculate your net operating income.
Sometimes, they use other factors to interpret the net operating income, which may change the report’s outcome.
Make sure you follow all these calculations to conduct a thorough cross-check from your end.
Another necessary calculation is the loan-to-value ratio. It is a mathematical comparison of the loan to the market value of the property. Depending on the down payment the investor makes into the property, the LTV will vary.
The more down payment you make, the lower the risk level will go for the lender.
See Related: Key Financial Statistics to Know
Other Variables Affecting Real Estate Underwriting
Besides the factors mentioned earlier, there are lots of other variables that can affect your underwriting process.
You should be familiar with these factors to make sure your property gets underwritten correctly.
Checking the rent growth is an essential factor in the underwriting process. If you make an investment based on the current rent amount, without considering potential market fluctuations, you can end up making a bad investment.
The vacancy rate of your investment property is calculated with two methods:
- How long it takes to find new tenants
- Eviction time an existing tenant would take before the new one moves in
You should make sure you calculate the value of your target property after taking both factors into account.
Gross Rental Income
The gross rental income will determine the cash flow and your property’s value. However, the net income, meaning what’s left after funding repairs and taxes, should be thoroughly calculated as well.
Properties with little or no net income are highly risky for lenders as they produce higher negative cash flows.
So, before your target property is underwritten, make sure you maintain the net income to a good level to lower your lender’s risk.
See Related: Pros and Cons of a Triple Net Lease
Potential Return on Investment
Most importantly, you should know the details about the potential return on investment for your property. There are lots of ways in which underwriters will measure your potential return on investment.
These include gross yield calculation and entry and exit cap rates.
The entry rate is relatively easy to calculate as it requires current market values only. However, calculating the exit rate; the price when the property is sold is tricky as it requires accurate income and market value forecasts.
You should keep an eye on the underwriter’s calculation for your cap rates, as these values might significantly affect your lender’s decision.
See Related: Real Estate Investing Terms to Know
That concludes our guide on how to underwrite real estate with useful tips for investors.
In a nutshell, an investor needs to comprehend how their asset manager will predict the underwriting report’s clauses for their property. On the other hand, as a lender, if you ignore these factors, you might end up in a risky investment.
Similarly, as an investor seeking a loan, even the slightest miscalculation in the underwriting may give a negative image of your property to the lender. This may even result in disapproval.
You must hire a professional real estate underwriter, whether you’re a lender or an investor, to do the job for you. Also, you should keep an eye on each of the calculations to make sure the transaction goes according to your expectations.
And that’s it. Remember, real estate investment is a risky business, so stay vigilant and confident, and you’ll quickly generate a passive real estate income for yourself.
- 16 Best Financial Advice and Tips
- Important Pros and Cons of Renting vs Selling Your Home
- Best Books on Flipping House