How do real estate investors and lenders really know if an income producing property is worth the price... and the risk?
A property that is cash flow positive today can quickly turn into a money-losing investment in future years if income projections are overly optimistic or the buyer uses too much debt to purchase the property.
Underwriting real estate is a complex process. It’s one of the least understood parts of qualifying for a loan, but also one of the most important to understand.
In this article we’ll look at how underwriting real estate works, and how rental property investors can learn to think like a lender to make better investment choices.
What is Underwriting in Real Estate?
Underwriting in real estate is similar to the preapproval process for getting a loan. Sometimes underwriting is automated – a process known as “desktop underwriting” -- and other times the process is done by a “real” person when a transaction is more complex or doesn’t meet Fannie Mae or FHA loan requirements.
Once the loan application and borrower paperwork are submitted for review, an underwriter may ask for more specific information about the borrower or the property. That’s one of the reasons why it sometimes feels like the process for getting a loan drags on and on.
On a $100,000 property a buyer using a conservative LTV may put $25,000 down with the lender making a loan for the balance of $75,000. Although no investor likes to be turned down for a loan, underwriting helps buyers and lenders to avoid placing valuable capital in a property that may underperform.
When they’re turned down for a real estate loan, experienced investors always ask “Why?” before approaching another lender. If the potential purchase doesn’t make it through underwriting, it may be a red flag that the deal doesn’t make good financial sense.
The Role of a Real Estate Underwriter
A real estate underwriter determines the security and risk level of the loan by researching the buyer credentials and the value of the investment. If the risk level is too high, the underwriter may ask for a larger down payment or higher interest rate so that making the loan is worth the increased risk.
Debt and collateral are two of the main metrics an underwriter uses to approve or disapprove the financing:
- DSCR (debt service coverage ratio) reviews the relationship between net operating income and the total loan amount
- Collateral securing the loan includes the borrower down payment and the difference between the appraised value and the market value
How Underwriting Real Estate Works
The underwriter is responsible for answering two important questions:
- Is the borrower a good risk who can be trusted to make the loan payments on time, and meet all of the terms and conditions of the loan?
- Is the property worth the loan amount if the borrower defaults and the property needs to be taken back by the bank and then resold?
At the end of the day, the underwriter is the person responsible for ensuring that borrowers can pay what they owe and if the property is capable of generating the anticipated income.
The underwriting process can take anywhere from a few days to a few weeks, depending on how complex the transaction is. Basic steps in underwriting real estate are:
- Review borrower assets and liabilities to verify income and net worth
- Consider payment history of borrower and the track record of paying different sources of revolving and non revolving credit on time
- Pull credit score and check credit history
- Analyze DTI (debt-to-income) ratio of borrower
- Appraise property to determine the market value
- Conduct title search to learn current ownership and existence of any liens
- Determine if the location of the property is subject to flooding, hurricanes or tornadoes, or other natural disasters
- Request additional information from borrower if needed
Understanding The Lender’s Perspective
Underwriters understand that investing in real estate is a numbers game, where facts are what matter the most. Financial metrics and measurements a real estate underwriter reviews include:
1. DSCR (debt service coverage ratio) to measure the amount of NOI (net operating income) needed to repay the debt service.Underwriters usually prefer a DSCR of 1.25 or higher. For comparison, a debt service coverage ratio of 1.0 means a property is generating only enough income to pay the loan, with nothing left in reserve, after the normal operating expenses have been paid.
2. NOI is calculated by the underwriter after reviewing the existing profit and loss statement, proforma projections, and tenant rent roll.Underwriters will oftentimes use different variables such as a high tenant turnover, no rent increases, or other market factors to determine the effect on the property net operating income.
3. LTV (loan-to-value ratio) measures the amount of the loan compared to the market value of the property. In the eyes of the underwriter, an investor who makes a larger down payment has “more skin in the game” and represents less risk because the LTV is lower.For example, a buyer making a $10,000 down payment on a $100,000 property has high-risk LTV of 90%. On the other hand, a conservative investor with an LTV of 75% is putting $25,000 of his own money into the deal, creating less risk for the lender.
Other factors a real estate underwriter considers include the property’s gross income and the potential for adding value.
A real estate underwriter also looks at the track record of the borrower. Experienced investors who are buying the same type of property they’ve already proven their success with increase the odds of getting a loan.
Variables Affecting The Underwriting Process
Although there may be dozens of factors that influence whether or not a loan is approved, there are five key variables that affect the underwriting process:
Rent Growth
The amount of rent and the forecasted growth has a direct affect on all other metrics used to analyze the financial performance of income producing property. Sometimes novice real estate investors “plug in” a fixed percentage rent growth amount, but that can lead to making a bad investment decision.
Some markets are more seasonal than others, so a property with a lease that expires in the middle of winter can take longer to rent. In markets with strong population and job growth, rent growth may be much higher than average due to an imbalance between supply and demand for rental property.
Vacancy Rate
Vacancy in rental property is created in two different ways. First, there’s the time it takes to find a new tenant when the old one leaves. Secondly, vacancy can also be caused by eviction and the downtime needed to make repairs before the property can be rented again.
Some property types can have higher vacancies than others.
For example, most tenants see a single-family house as the most desirable type of property to rent, because it feels more like home. This means that vacancy rates will usually be lower. However, a house will also be 100% vacant between tenants, while units in a multi tenant property are rarely vacant at the same time.
Cash flow Forecast
By accurately predicting rent growth and vacancy rates, investors and underwriters can create more reliable cash flow forecasts.
Gross rental income or cash flow is the total amount of revenue a property will bring in, while net cash flow or net operating income is the money left to pay operating expenses and service debt.
Net income is what’s left over to fund emergency repairs, pay taxes, and put money in the bank as profit. A rental property with little or no net income represents a higher risk to the underwriter and the investor because the potential for negative cash flow is greater.
Potential Return on Investment
There are a variety of ways to measure investment return, including gross yield, cash-on-cash, and IRR (or annualized rate of return). But one of the simplest measures of return are the entry and exit cap rates.
The entry – or “going in” – rate is easy to calculate by dividing the actual net operating income by the current market value of the property: Cap rate = NOI / Market value.
However, the exit cap rate – or the “going out” – cap rate at the time the property is sold is much more difficult to predict. That’s because accurate forecasts must be made of what the rental income, operating expenses, property market value, and what cap rates for similar property will be several years in the future.
One reason an underwriter forecasts cap rates going forward is to compare the quality of the property collateral to the loan balance. A property that loses value over time because rents decline or because operating expenses disproportionately increase represents more of a future risk to the lender than a rental property that generates healthy net cash flow year over year.
Final Thoughts
Underwriting in real estate helps lenders and investors avoid putting capital in a property that has a high risk of becoming a problem. No investor likes to be turned down for a loan or asked to make a bigger down payment and accept a higher interest rate and more restrictive loan terms.
By understanding how real estate underwriting works, investors can learn to think like a lender and make better decisions about the rental property they buy.
