Underwriting is a process where risk-takers would specify the level of risk they are willing to bear in exchange for a specific premium they are seeking, which is also known as underwriting risk. Underwriting plays an important financial role in insurance, investment and real estate. Real estate underwriting is used by lenders to determine the level of creditworthiness of a potential borrower. This includes fact-checking and conducting due diligence on the borrower before approving the loan.
Real estate underwriting also consists of the underwriter examining the property’s appraised value and sale price to determine any inconsistencies between them. This allows the lender to analyse loan applications and ensure that all possible risks are made known, including conducting a check on the borrower’s credit history and on the reasonableness of the property’s market value.
Underwriting and real estate
Underwriters in real estate handle real estate loan requests to determine the level of risk that the lender is willing to bear. They take into account various factors surrounding both the borrower and the real estate (the asset) involved. In real estate, the underwriting process usually goes through preliminary vetting, followed by secondary vetting.
Real estate underwriting is important for lenders to understand their risks before approving a loan. In most cases, the real estate asset acts as collateral in the event of a default. Underwriters make use of the debt servicing coverage ratio (DSCR) to establish that the income generated by the property can cover the interest to service the requested loan, hence reducing the risk of loss to the lenders.
Preliminary vetting process
Lenders typically look into the sponsors, the details of the real estate deal, as well as the property itself. This includes vetting the sponsor’s credentials, their projections, their pro forma estimates, and the property’s proposed floor plans.
In real estate, the sponsor manages the real estate project on a day-to-day basis. This includes the acquisition of the land, contracting the design, construction and leasing work, as well as any future sale of the real estate asset. Because of the sponsor’s significant role in the project, it is important for the lender to vet the sponsor thoroughly to assess any potential risk the sponsor may bring and whether the sponsor can see the project through from start to completion.
Vetting the sponsor’s credentials includes assessing the sponsor’s experience and track record within the specific market and asset type, the status of any general partners involved in the project, as well as the individual experience of each member of the sponsor’s team. In addition, the lender would be interested in the sponsor’s history, such as the ability to pull through prior economic declines and how the properties have performed in the past.
2) Sponsor’s projections and pro forma estimates
The sponsor formulates projections for a real estate project, such as the projected returns and expected performance of the property. During the preliminary vetting process, the lender should verify these projections and pro forma estimates to determine if they are achievable given the existing market conditions, while also applying a discount to the projected figures for a more realistic or conservative outcome.
Additionally, the lender should examine the sponsor’s worst-case scenario and use this as the basis for the underwriting.
3) Property’s floor plans
The floor plan allows the lender to understand how the property is going to be laid out and evaluate if the floor plan is conducive to the market at the time of completion. Most importantly, the lender should be able to assess the floor plan and calculate any additional costs if changes are required, factoring other risks involved.
Secondary vetting process
A more detailed process, consisting of site visits, looking at comparable prices, property titles, tenancy contracts, occupancy history of the property, financial analysis, as well as an appraisal.
1) Site visits
The site visit can provide more information about the property’s location and condition, providing the lender an indication of the necessary improvements to reach the return goals. This also allows the investor to verify the class of the property, in the case of commercial properties. The site visit may also extend beyond the property itself, such as the neighbourhood, amenities and demographics in the surrounding area, which can provide clarification or reassurance for potential investors or lenders.
2) Comparable prices
Examining comparable prices is an important part of the underwriting process, both for residential and commercial properties. Comparable prices refer to the prices of comparable properties in the vicinity and can be a good measure of a property’s market and projected value. Some points of comparison include the property’s land area, proximity to amenities, rental prices and occupancy rates.
3) Legal tasks
When vetting a property deal, it is key that any potential investor or lender is aware of the legal requirements and licenses required. This includes ensuring that the property type is in line with the zoning of the area, as well as ensuring the sponsor is equipped with the necessary permits to carry out the project.
In addition, the lender should check the property’s title to verify that the seller has ownership rights to the property, which may be obtainable publicly, depending on the location of the asset. This step ensures that the lender or investor can rely on the seller being in compliance with the regulations in place within the property’s jurisdiction.
The tenants of the property should also be vetted by the potential lenders or investors, since their payments contribute to a significant portion of the property’s revenue. More specifically, the underwriter should verify the amount and dates at which the tenants are making payments. These figures provide an estimate of the total rental revenue, the long-term sustainability of this revenue, and any possible effect on the projected returns. Auditing the tenant’s leasing agreements can also reveal any potential liabilities and the long-term cash flow stability of the real estate asset.
5) Occupancy history
An asset’s occupancy history determines the stability of the property and whether this fits into place with existing projections. For example, value-add properties may have lower occupancy rates in its occupancy history, which may be less indicative of future performance as compared to core investment properties.
In this scenario, the underwriter may have to make estimates for a more realistic occupancy rate based on current and future tenants during the investment period. However, as occupancy rates may vary significantly depending on the property type and the market, it is important to factor in the occupancy rates of comparable properties for a more realistic measure of performance. Low occupancy rates can be indicative of higher risks for investors and lenders, which should be highlighted as part of the underwriting process.
6) Financial analysis
A financial analysis includes the underwriter analysing the pro forma and determining the budget breakdown. The pro forma consists of an estimation of actual and projected revenue and costs for the real estate project. This gives investors an expected rate of return for the investment. During the vetting process, the underwriter verifies the reliability of the pro forma estimates in the current market conditions, as well as in the face of potential downturns in the future.
Within the budget analysis, the property’s net operating income is calculated, along with comparisons of the expected cash flow during the investment period. The underwriter also considers the expenses incurred by the property to determine the monetary returns of the property, giving lenders and investors some insight into the actual value of the investment.
An appraisal is required for a majority of commercial property loans, which includes the appraised value of the property based on comparable prices, the net operating income, and the corresponding capitalisation (or cap) rate. The appraisal is typically carried out by a third-party appraiser as determined by the underwriter. If multiple appraisals are undertaken, the final value is usually taken from the average of the appraised values.
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Disclaimer: The information and/or documents contained in this article does not constitute financial advice and is meant for educational purposes. Please consult your financial advisor, accountant, and/or attorney before proceeding with any financial/real estate investments.