Back-of-the-napkin numbers are an excellent way to know if a property is worth more than a passing glance. However, they are insufficient to base a successful deal or secure financing. To ensure a commercial real estate investment will make money, you must devote time and research to properly underwrite it. The figures from this process will enable you to move forward or walk away.
Successfully underwriting a commercial real estate investment uses historical data and well-researched projections. The financial analysis must include full details on the property, including leasing, releasing assumptions, vacancy rate, construction costs, operating expenses, and debt assumptions.
Banks and investors are not the only people who need a properly conducted underwriting process. You, the person interested in the project, require the data the financial analysis produces. General figures from rental income, property tax, and insurance management fees can produce false profit predictions that could cost you money. So, underwriting is crucial even if you’re paying in cash.
How To Underwrite Commercial Real Estate
Underwriting commercial real estate takes time. It will require two weeks minimum for a straightforward property. The bigger the project and the more renovation and construction involved, the longer it will take to gather all the necessary data for the financial analysis.
Thus, the first step should be the back-of-the-napkin figures. Often, these can be done over lunch. If these don’t look good, then walk away. There is no point in sinking so much time and research into a project that looks unprofitable. However, if the project shows promise, it is time to gather your data and crunch the numbers.
Get Your Spread Sheets And Financial Models Ready
You need to have a data entry system and financial models ready to crunch the data you will gather. The pro forma will produce the property’s cash flow, looking at income, expenses, and debt service. However, within these three categories are numerous variables and metrics.
Some investors build these themselves; others buy templates and packages with already-baked formulas. The granularity of a pro forma often reflects the complexity and scope of the projected project. Be aware that the ones buyers use for a commercial real estate investment are typically different from the banks, as financial institutions have different goals and objectives.
Gather The Details Of The Commercial Property
Gather as much information as possible about the property. Information you’ll want includes:
- Year it is built
- Size of total property
- Square footage of the building(s)
- Square footage of leasable space
- Location
- Condition
- Sales history
- Market demand
- Demographic
Get The Full Details Of The Current Leasing Agreements
Find out all current leasing agreements. You want the full details, beyond the current rent:
- Current rent
- Agreed increase schedule
- Start and end date of the leasing agreement
- Square footage of the leased space
- If there are any expense reimbursement agreements
- What maintenance are they responsible for, and which are provided by the property owner
Assess How Likely Tenants Will Renew Their Leases
Examine all the current tenants and organize them by the end of their leasing agreements, from who is expiring first to who is locked in the longest.
Next, gauge how likely your current tenants will want to renew their lease. If they do, will they maintain their size, hoping to expand into other rental units or downsize? Also, check for any agreed leasing broker fees if the tenant renews.
You may have to get creative in your research to determine the business’s health and how happy the current tenets are with their location.
Determine The Vacancy Rate
It’s essential to determine the property’s vacancy rate even if you have a favorable outlook on current tenants renewing their leases. The property’s historical data should indicate how often there are vacancies, how many at one time, and how long it typically takes to find a new tenant.
Also, try to glean as much information as possible from similar properties in the area. The information will create more realistic projections, especially if the property is newer and doesn’t have a deep history to mine.
If you want to change the rent structure and agreements, estimate how this will impact the vacancy rate.
The costs of a property standing vacant are typically higher than the loss of rent:
- Repairs, repainting, and other maintenance after a tenant vacates
- Advertising or leasing broker fees to refill the space
Gather Estimated Startup Costs
If there is any construction or remodeling on the cards for the property, you need to consult contractors and other experts in the field to get cost estimates for the project.
Be sure you include:
- Any legal and permit fees for the construction
- Any vacancies or reductions in rents during the remodeling
- Length of time the project would take
Assess The Property’s Operational Costs
Properties have operational costs. Historical and current data must be obtained to help create increase predictions. Also, research any proposed laws, tariffs, tax hikes, or predicted rate increases that might cause expenses to spike above inflation.
Property operational costs generally include:
- Property management and administration fees
- Legal fees
- General maintenance of the building and grounds, such as landscaping and security
- General repairs
- Insurance premiums
- Property taxes
- General Utilities
Add In Financing Costs
There are additional costs to factor in if you are financing the project through loans. However, the debt service is based on more than the monthly repayments. Other data to factor in:
- Any fees included in the repayments
- Any fees in the loan process
- How long will your payments only be paying off the interest
- Payments to any other investors, including if they are on a percentage increase
Factor In Your Exit Strategy
Consider how long you plan to own the property before selling it. Questions to ask when determining an exit cap rate include:
- When is the project sell-off date?
- What is the estimated property worth?
- How much of a sale goes to a broker’s commission?
- How much of a sale goes to taxes?
- Other closing fees to consider, including legal?
- What is the agreement with investors in the event of a sale?
Conduct A Sensitivity Test
Conduct a sensitivity test on your data by changing the variables so you can look at various scenarios and see how well your cash flow can withstand the variables of a fluctuating market. Figures to play with include:
- Occupancy rate
- Rent growth rate
- Exit cap rate
- Interest rates
- Expense growth rates
Don’t assume the average or above-average figures are good enough. Also, assess how well the property could perform in a downturn or recession. At the very minimum, you should have three sets of figures:
- Best case
- Projected (assumed) case
- Worst case
Conclusion
A successful underwrite shows you the full potential and pitfalls of a project. The crucial information will do more than secure financing: it will save you from making ruinous investments. The more data you can plug into your model, the more accurate its predictions for the various scenarios you and your investment might face. Underwriting takes time, but it’s a money saver in the end.