The process of underwriting in commercial real estate acquisitions provides the risk assessment and financial analysis required to ensure a project is viable in the current market and has income-generating potential. Lenders, investors, and developers use the underwriting process to align the financial viability of a real estate project with their own risk tolerance and investment criteria. Underwriting is essential to make sure a financial transaction is low-risk and has the potential to deliver high returns before committing funds. CRE underwriting helps guarantee a fair return on investment for all stakeholders, and is a crucial step in a project’s lifecycle.
Here’s everything you need to know about real estate deal underwriting, and how development teams can get the process right:
What Is Commercial Real Estate Underwriting?
Commercial real estate underwriting is the foundation of all investment decisions, allowing lenders or investors to do thorough risk assessment on a property. Underwriting allows development acquisitions teams to determine if a deal is viable, high-risk, or merely promising. Key components to consider in the underwriting process include:
- Cash Flow: Financial forecasting and pro forma to look at future income and expense projections to forecast the property’s potential cash flow.
- Cap Rates: Cap rates in commercial real estate project the risk and return on an investment asset by evaluating the relationship between net operating income (NOI) and asset value. Determining the cap rate is found by dividing the asset’s NOI by the asset’s sale price.
- Expenses: Calculating expenses, such as operating costs, property taxes, and capital expenditures for repairs or upgrades, is essential for creating an accurate underwriting projection.
- Sensitivity Analysis: A pro forma sensitivity analysis evaluates how changes in key assumptions impact a financial expectations, allowing acquisitions teams to identify best case, worst case, and most likely scenarios
Historically, the underwriting process has been managed in outdated and error-prone workflows such as spreadsheets or disparate email systems. Real estate development software is streamlining the process for acquisitions teams, allowing for AI and automation to facilitate nearly every key component and step of the development process.
The Real-World Stakes of Getting It Right
Development teams who do not complete a thorough underwriting process will see major downsides over the project lifecycle. Failure to mitigate risk and conduct thorough financial analysis can have real-world implications on a project, derailing budgets or taking projects off expected timelines. The key risks of an insufficient underwriting process include:
- Overpaying for land. Land acquisition is one of the greatest expenses a developer will have to make in pursuing a real estate project. You can avoid overpaying for land by researching current market conditions and doing a comparable sales analysis to understand what fair value for the purchase would be. Evaluating a property’s condition, location, and resale potential are also important for understanding the appropriate value of a piece of land before moving forward with the acquisition.
- Underestimating costs. Due diligence, with thorough expense projections, is essential to avoid underestimating costs. Expense projections should include all operating expenses and vacancy rates determined using market history and other realistic metrics. Contingency funds can also be set aside to address potential shortfalls once your team has a better understanding of the risk.
- Unrealistic revenue assumptions. In addition to avoiding underestimating costs, it’s good to avoid overestimating potential profits. Revenue assumptions should be made leveraging data about comparable market rents and current vacancy rates. Historical data from comparable properties in your portfolio can also be a major asset in trying to predict assumptions.
Flawed underwriting processes, such as bad comp data or outdated models, can lead to project failure. For example, if a multifamily mixed-use housing project is slated for construction in a volatile market, external factors can derail the project. If population growth is not as strong and economic conditions are not adequately accounted for, tenant occupancy could be weaker than expected and retail assets in the mixed-use building could underperform. Ensuring accurate projections for a project’s profitability is necessary to ensure the expected returns are made available for owners and investors. Deal management software can play a key role in avoiding these pitfalls, allowing acquisitions teams to adequately mitigate risk and ensure financial viability.
The CRE Underwriting Process Explained
The CRE underwriting process has several main components, including market analysis, cost assumptions, and modeling financial scenarios. Your acquisitions team can set projects up for success by moving through a few key steps in the process.
Market and Asset Analysis
Analyzing market and asset data is an essential step in the underwriting process, allowing your team to better understand the potential returns on a project, as well as any projected risk.
- Site Comps: Be sure to look at comparable properties in the same market to better determine a property’s market value, investment potential, and overall financial potential. Factors to consider in a sales comp include location, property type, market conditions, and geographic or economic factors that might have an impact on tenancy.
- NOI Projections: Net operating income (NOI) projections are found by subtracting a property’s operating expenses from all the revenue generated by the property. NOI offers unique insight into the core operational expenses of a property and expenses on the property level.
- Lease Assumptions: Lease assumptions refers to the forecast for a property’s future rental income once tenant leases expire. This metric can be found by predicting market rents, considering tenant improvement costs, down time where units might be vacant, and any other factors that might impact lease terms.
- Location Trends: Location analysis allows development teams to consider broader trends as part of the acquisitions process, including proximity to public transit or other amenities, infrastructure in place to support the local economy’s growth, and the outlook for housing supply in the chosen region. Understanding the location of an area more deeply will allow your team to avoid any unforeseen obstacles, such as weak population growth or oversupply leading to insufficient tenant demand.
Cost and Schedule Assumptions
The current construction environment is making getting projects completed more difficult than ever. From rising material costs to labor shortages, it’s increasingly vital to get cost and schedule assumptions right on your projects. Here are some key considerations in your schedule and cost assumptions:
- Construction Budget: In order to qualify for a loan, developers will need to compile a thorough construction budget that accurately details total project costs. Lenders will want to see a detailed breakdown of costs for materials, labor, and other necessary expenditures, with a contingency fund allotted for unexpected costs. The construction budget is essential for establishing an accurate loan-to-value ratio and for establishing the draw schedule between borrower and lender.
- Timeline: Establishing an accurate timeline for your project is essential to secure loan approval and to mitigate risk. Construction timelines should include project’s phases, vendor selections, and any potential delays that could arise and change the situation. Historical data can play a key role in the accuracy of your construction timeline, allowing you to look at vendor’s past performance to better evaluate outcomes on your current project.
- Income Modeling & Contingency: Financial analysis allows acquisition teams to understand a property’s future revenue potential and make cash flow projections. Underwriters can use financial modeling to conduct sensitivity analysis, testing how certain market conditions or assumptions could impact returns. Once acquisitions teams have used income modeling to better understand risk, an accurate understanding of the contingency necessary can be determined and these funds can be set aside.
In general, cost and scheduling workflows are difficult to track across teams, and operating in spreadsheets and disparate email threads makes these processes even more error prone. Centralizing your development pro forma in a single modern platform can help you increase visibility on key deal information and minimize risk.
In addition to projecting construction costs, your team can also look at other forms of historical data or financial forecasting metrics to keep costs on track. Here are a few other metrics to consider as you move through the underwriting process:
- Rent roll: Rent roll underwriting requires compiling a list of the property’s tenants and lease terms to assess a property’s income-generating potential, predict cash flow, and calculate NOI. The rent roll helps determine the income a property is generating, and can better predict a property’s market position.
- Debt assumptions: In the final stretch of your underwriting process, you add debt assumptions into the pro forma model. This can include loan proceeds, the interest rate used to calculate monthly payments, the amortization period, and any interest-rate period before amortization begins. Lenders and investors can offer an idea of these numbers before you add them to a pro forma.
- Return targets: Return targets typically require calculating the Internal Rate of Return (IRR), with stabilized deals targeting 7-11%, and higher risk development projects aiming for 15-20%. Higher risk profile projects require higher return targets so investors are compensated for the uncertainty. DCF models for real estate development teams can help your team better understand financial risk on a project and set target returns.
Common Pitfalls in Traditional Underwriting
Traditional underwriting often relies on outdated spreadsheets and siloed email chains, both of which can leave your project vulnerable to pitfalls, including errors in manual input, version control issues, and lack of transparency, Here are some of the most common obstacles that arise in the underwriting process, and why these tend to occur.
- Manual inputs = high error risk. Labor intensive modeling is time consuming and leaves developers with less time to consider and evaluate deals. Developers end up evaluating less deals, or less deal scenarios, and are therefore unlikely to end up with the highest or best use case deal at the end of the process.
- Version control issues when multiple teams are collaborating. If your key deal information is stored in disparate systems, there are more likely to be version control issues when your team needs to work cross functionally.
- Lack of pipeline visibility and outdated spreadsheet data. Your team will need to manually go in and update deal information when it’s tracked in spreadsheets. Without a real-time view of the pipeline, there’s no way for acquisition teams to quickly determine where a deal stands or which tasks are the most important to prioritize. The lack of transparency and siloed deal information slows teams down and can cause you to lose out on competitive opportunities.
How Northspyre Helps You Underwrite Smarter
Modern deal management software can play a key role in your underwriting process. Instead of working against your existing workflows, Northspyre automates budget tracking, integrates historical project data, and keeps assumptions visible in real time. Northspyre Deal brings together underwriting and pipeline management, providing acquisitions teams with the ability to conduct faster evaluations, create cleaner pro formas, and minimize the risk of post-acquisition surprise. The platform is built for acquisitions leaders, helping improve the speed and reliability of financial analysis, superior deal pipeline management, and the ability to collaborate effectively across your deal pipeline.
Learn about how Northspyre Deal can help your acquisitions-focused development team get to market faster with conviction in your bids.
