If you are looking to build your real estate empire, you need to learn about real estate underwriting. This is a fancy term for doing the financial analysis and modeling on a target property that you maybe interested in acquiring. This is critical to making sure that this potential investment is the right one for you.
Why can’t you just take the information that is provided in the sale packet from the listing agent and use that? Because, having a standard and consistent way for you to analyze real estate deals allows you to compare the current one you are working on to previous deals you looked at. It makes sure that all the data is in the same categories, nothing is overlooked and it prevents you by being swayed by the agent’s overly optimistic proformas in their pretty sales packet. Cause real estate sales guys would never embellish an investment property 😉
While you can do real estate underwriting for a single family home or a small apartment, what I will discuss in this article is more about doing it for a 20+ unit apartment building or complex. Here are the broad steps, we will drill down into them below:
- Initial high level underwriting (10 minutes)
- Initial high level market and rent research (10 minutes)
- What if scenarios and value add brainstorming (10 minutes)
Notice this is 30 minutes or less. This is just to see if this real estate deal might make sense. We are not jumping in our car (or buying plane tickets), calling the listing agent, calling your banker. This is just the initial smell test to see if we should spend any more time on this deal.
Before we begin, I should outline that this data is collected in a underwriting spreadsheet. There are tons of these spreadsheets on the internet. I find more are very complex and difficult to use, especially for the initial quick underwriting. Look for one that is very simple or design one yourself. Here is a screenshot of the input page on the one that I use. As you can see, it is fast and simple. This initial page is enough sometimes to do my quick analysis. It then links to a 1st year and 10 year financial page that allows me to put more what if scenarios.
Initial high level underwriting (10 minutes)
This step is the data gathering exercise. You are taking the data from the sales packet from the listing broker and populating your spreadsheet. The sales packet should include a T12 (trailing 12 month) income statement versus a potential proforma (one that was made by listing agent using estimates). Many of these T12 will have dozens of lines on them that do not fit into your spreadsheet. If they are trivial amounts for misc items (such as postage, key replacement, advertising, etc), just ignore them. If they are larger or more relevant to this particular property (HOA fees, onsite caretakers, internet expenses), find a place to add that to your spreadsheet. You are essentially building your budget.
Listing agents will often give you “market rents” for units that are rented for lower than market. At this point in your process, use actual numbers. If you buy this building, you are going to be receiving those rent for a while until you can raise rents (which might be 60-90 days). Plus, those market rents might only be attainable by having a current tenant vacating and renovating or upgrading the unit (using capital)-you may not be able to do all the units at the same time. We will factor in income and expense improvements in the last section for what ifs.
Initial high level market and rent research (10 minutes)
This step is to validate the market rent amounts and area of the prospective property. The listing agent says that current rent is $700 per unit, but could be $900. You need to validate that. Use your local knowledge, Craigslist, Rentometer.com and even local property managers to confirm that the market rent really should be. Remember that getting to market rent may require more than just increasing rents on existing tenants. You may need to make improvements in the units or commons areas to achieve that higher market rent.
Second is to analyze where this property is located. Is it in a desirable area? Is it near bus line or shopping? Are the rents low because it is in a non-desirable area or difficult access?
Are there photos of the property included in the sales packet. While most agents will send only the best photos, can you pick out an common condition from the photos? Are all the cabinets old? Are none of the bathrooms updated? Can you see marks on the walls or damaged blinds in units? What type of cars are in the lot (new, used or broken down)?
What if scenarios and value add brainstorming (10 minutes)
If you agree that the market rents seem achievable and the property is not located next to a sewage plant, is the time that you put your creative hat on. Review your spreadsheet. Adjust your income numbers to the market rent amounts. What does that do to the cap rate and income? Review the expenses. Do any of them look high such as utilities? Could you lower them by making improvements or even considering using RUBS (Ratio Utility Billing System is a method for allocating master billed utility expenses to residents of a multifamily community) to shift the costs to the tenants? Next take a minute to estimate your capital investments that need to be made to improve the rent or decrease expenses like bad debt or lost rent. Can you use capital to reposition this property such as from a C- grade property to a B+ property thereby increasing the desirability and rent which in turn increases the value of the real estate?
The spreadsheet that I use has a 10 year financial sheet that summarizes income and expenses, but allows me to quickly plug in some changes. An example is that in the first year, I may spend $50k to renovate 10 apartments which will results in my rents increasing from $700-900. In years 2 and 3, I may renovate 20 apartments each year and increase rents. But my spreadsheet also allows me to take into account the higher vacancy rate as I take these units offline for 1-2 months to renovate. Most of the more complex real estate underwriting spreadsheets you find on the internet have this option.
You can see that doing underwriting on a real estate deal is not difficult and only takes maybe 30 minutes to do an initial look at deal. When deals pass all these tests and looks like it might be a deal you want to pursue, your next steps are to do deeper dives on all these areas to confirm your assumptions and the numbers/data that you were given by the listing agent. Happy hunting!