What Is Underwriting in Real Estate?
Real estate underwriting is the process of assessing the risk and potential returns of a real estate investment opportunity. It refers broadly to the vetting process of a real estate investment. In the world of single-family home-buying, underwriting is associated mostly with mortgage officers and the issuance of loans. Underwriting in commercial real estate investing is a related but more complex exercise, and can apply to both lending (CRE debt investments) or real estate private equity investments.
The concept of underwriting originally came from the insurance industry; invested by Lloyd’s of London in the 17th century. Underwriting has since evolved to become a fundamental exercise in various financial sectors, including real estate. You may think first of a mortgage lender underwriting a loan on a house. However, underwriting in real estate also applies to professional commercial real estate investors and lenders when considering investments. The same basic idea applies: what are the risks, and am I (as lender or investor) being compensated adequately in terms of return potential.
For accredited investors considering the commercial real estate (CRE) market, a deep understanding of underwriting intricacies is crucial. This article explores the essence of underwriting within real estate, showing its significance and impact on investment decisions.
Underwriting in Real Estate, Defined
The process of qualitatively and quantitatively determining if a real estate investment is worthwhile based on projected risk-adjusted returns.
Underwriting in real estate investing is all about understanding risk.
In commercial real estate, underwriting may address more factors and involve more parties in determining the soundness of a potential investment. In either case, underwriting in real estate is a key phase of the investment process in which risk factors are carefully considered. For any sponsor, real estate asset manager, or individual passive investor, underwriting is key to making sound decisions on whether to proceed with the investment.
Simply put, conducting thorough underwriting on behalf of individual investors is a core value that EquityMultiple provides.
Underwriting is a key process by which total origination volume — the flow of potential investments evaluated — is pared down, and only vetted investments selected. (Stats as of Q2 2024.)
Underwriting in Commercial Real Estate
At its core, real estate underwriting involves a thorough analysis of both the property in question and the borrower (the sponsor or operator). For lenders, this process ensures that the borrower can service and ultimately repay the loan. For investors, especially those involved in real estate crowdfunding platforms, it assures that the property, operator, and business plan have been thoroughly assessed. Underwriting in real estate investing qualitatively and quantitatively addresses the question: does this investment project to appealing returns relative to risk?
Underwriting in the real estate crowdfunding space is vital. Individual accredited investors are increasingly looking to tap into potentially lucrative commercial real estate opportunities through online platforms, and as a result, transparent, thorough underwriting is key.
Try thinking of underwriting as a safety net. It weeds out properties that might not offer sufficient return potential versus risk, ensuring that only the most promising investments are presented to investors.
Underwriting information for individual EquityMultiple investments is available while logged into the platform.
What Does a Real Estate Underwriter Do? (Underwriting Best Practices)
Whether you’re a lender, an investor, or a property developer, understanding the best practices in underwriting can save you from potential pitfalls. Here are the key practices to consider:
- Due diligence: This involves a thorough investigation of the property. Location, market trends, property condition, and potential rental income should be examined. Moreover, underwriters should ensure there is no one else on the property title and assess potential risks like natural disasters.
- Sponsor check: Lenders and crowdfunding platforms alike should examine the borrower’s financial status. This includes credit history, current debts, and overall financial health. Underwriters should determine a potential borrower’s creditworthiness by assigning them a rating based on credit scores from the three major credit bureaus.
- Detailed financial analysis: Underwriters scrutinize the pro forma and other quantitative elements of the business plan, such as market comps. They use metrics like the debt-service coverage ratio (DSCR) to determine if the property can generate enough income to cover loan payments, especially in cases where the property serves as collateral.
- Property valuation: Underwriters order and review property appraisals to determine if the property’s value aligns with the loan amount requested. For example, if a borrower wants to purchase a home for $400,000 that an appraisal values at $300,000, the underwriter may not approve the full loan amount.
- Legal scrutiny: Underwriters ensure that the borrower and property have no legal disputes. Clear titles, verified ownership, and compliance with zoning laws are critical.
- Risk assessment: Underwriters identify potential risks, whether they’re related to the property’s location (like natural disaster risks) or market volatility.
Remember, rigorous underwriting can be the difference between a successful investment and a costly mistake.
One key benefit of investing via EquityMultiple: our team conducts underwriting on your behalf. While you may still want to do your own due diligence on any particular investment opportunity, you can rest assured that our Investments Team conducts several layers of underwriting before any potential investment makes it onto the EquityMultiple platform.
Underwriting Challenges
Underwriters face several key challenges when evaluating loan applications:
- Incomplete borrower information: In some cases, applicants submit partial or outdated financial records. Skilled underwriters know how to efficiently gather missing data and verify key details.
- Overvalued appraisals: In hot markets, appraisals may inflate property values. Experienced underwriters scrutinize comps and market trends to identify and rectify inflated valuations.
- Changing market conditions: Economic shifts can swiftly impact borrower qualifications and property values. Top underwriters stay current on market dynamics, and adjust their analyses in turn.
To navigate these issues, skilled underwriters make use of their expertise, review the various data sources at their disposal—forms, reports, records, and so on—and apply sound judgment. They know when to dig deeper on applications and how to balance risk mitigation with business goals.
Underwriting in Real Estate — a Current Perspective
Following a period of rapidly rising interest rates and some moderating macro growth indicators, underwriting comes into additional focus. While underwriting is critical in any market, quality underwriting carries specific implications in moments of capital market fluidity and/or economic uncertainty:
- Healthy NOI is at a premium, as debt service can quickly erode profitability in periods of rising or elevated interest rates.
- Risk mitigants in the market or submarket are important to consider, as a downturn in economic conditions can effect rent rolls if a local economy is not sufficiently diversified. Barriers to entry or supply constraints are examples of potential mitigants.
- Sponsor underwriting takes on a specific flavor. EquityMultiple conducts rigorous evaluation of sponsors. Amid fluid economic and capital markets conditions, EquityMultiple puts particular emphasis on sponsors who have a track record of success through market cycles.
Inflation is another example of a contemporary consideration in underwriting. Inflation has hit various inputs in real estate operations, including raw materials, utilities, and labor. Insurance of various types has been particularly affected. Part of EquityMultiple’s underwriting is ensuring that the sponsor has adequately and conservatively reflected these cost line items in pro formas and stress testing.
Our proprietary market scoring matrix is one key component of underwriting at EquityMultiple.
The Commercial Real Estate Underwriting Process
Commercial properties come with their own set of challenges and opportunities. The underwriting process, therefore, needs a slightly different approach compared to residential properties.
In commercial real estate underwriting, the focus is often on the property’s potential to generate income. Factors such as the property’s location, the stability of rental income, tenant profiles, and market conditions play a crucial role. For example, a commercial building in a thriving business district with long-term lease agreements is likely a safe bet.
Another essential aspect is the property’s operating expenses. These should be weighed against potential income to gauge profitability. For accredited investors, understanding this aspect ensures that they are stepping into a venture that aligns with their financial goals.
Underwriting in real estate transactions usually occurs over several phases:
- Underwriting by the sponsor, developer, or operator: does the property and thesis fit their strategy and capital parameters?
- Underwriting by lender(s) — much like a single-family purchase, lenders look total leverage and loan services versus collateral and the financial health of the borrower. Lenders may also look at loan servicing costs versus NOI (the sponsor’s DSCR)
- Underwriting by LP investors — whether equity investors are institutions, wealthy individuals, or platforms like EquityMultiple (and their investors), savvy LP investors will conduct their own underwriting as well, including due diligence on the sponsor (borrower).
Underwriting in Real Estate Crowdfunding
With the rise of fintech, real estate crowdfunding has emerged as a popular choice for individual accredited investors. Platforms like EquityMultiple offer a steady, diversified flow of opportunities across commercial real estate sectors. With a steady pipeline of complex investments, rigorous and regimented underwriting is all the more critical.
In the real estate crowdfunding model, the onus for underwriting should mostly fall on the platform and its personnel, but the individual investor should be at least familiar with the process, if not somewhat involved.
From the individual investor’s perspective, here are some underwriting steps to consider:
- Platform vetting: Before an investment opportunity is listed on a crowdfunding platform, it undergoes rigorous scrutiny. Platforms often have their criteria for property selection, ensuring only the best get through.
- Transparency is key: Accredited investors must have access to all relevant information. This includes details about the property, projected returns, and any associated risks. Platforms should offer detailed insights into their underwriting process.
- Diversification: One of the benefits of crowdfunding is the ability to diversify your investments. Instead of putting all your funds into one property, you can spread it across multiple ventures. Effective underwriting should facilitate this by offering a range of vetted properties.
- Alignment with investor goals: Finally, underwriting should ensure that the listed properties align with the overall investment goals of the platform’s user base.
An example of a capital stack in an EquityMultiple investment that has passed the underwriting and due diligence process. The more parties and financial instruments involved in the transaction, the more extensive the underwriting process.
What Does Underwriting a Real Estate Investment Entail at EquityMultiple?
Real estate investing platforms of today take various approaches to real estate underwriting. Some platforms leave underwriting to sponsors who raise capital, operating more as a “posting marketplace.” EquityMultiple, on the other hand, conducts significant underwriting in several stages on behalf of individual investors.
EquityMultiple employs a conservative yet strategic underwriting philosophy, rooted in a deep understanding of market dynamics and a commitment to transparency and due diligence. Our approach ensures that only the most promising and secure investment opportunities are presented to our investors.
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For example, when considering an investment in industrial property, our underwriting team conducts an in-depth analysis of the property’s location, tenant mix, lease terms, and the local industrial market’s supply and demand dynamics. This comprehensive approach ensures that we present only the most promising and secure investment opportunities to our investors.
These are the typical steps taken by EquityMultiple’s Investments Team to underwrite each investment we see:
- Initial screening: An associate from our Investments Team assesses the sponsor and project at a high level, what you might call a “sniff test.” EquityMultiple maintains proprietary scoring frameworks for markets, real estate sectors, and proposed leverage for transactions. Many investments evaluated to not pass this first step based on these frameworks.
- Sponsor due diligence: EquityMultiple assesses the track record of each sponsor considered for the platform, including creditworthiness, track record, background checks, and more.
- Stress testing and scenario modeling: EquityMultiple’s Investments Team examines the sponsor’s own underwriting, including projection of exit cap rates, assessment of market comps, expected market rent growth, and other factors. In many cases, underwriters at EquityMutliple will conduct our own modeling of cash flows and potential returns, building on what the sponsor has provided (Learn more about cash-flowing assets.)
- Identification of risk factors: EquityMultiple’s team seeks to identify any other potential risks to the business plan, which are documented clearly on each investment offering page within the platform.
- Review and voting by Investment Committee: Lastly, each investment must pass a final vote by the Investment Committee, comprised of senior leadership and real estate industry veterans.
Ultimately, only around 5% of potential investments pass underwriting and are featured on the EquityMultiple platform.
Underwriting in Real Estate Investing — the Bottom Line
Real estate underwriting is the backbone of a strong real estate portfolio. Underwriting in real estate is a specialized process that takes industry knowledge, local knowledge, and analytical skill. Even so, accredited investors can take part in the process and make informed decisions; they may take it upon themselves to do their own underwriting and due diligence, however cursory, on each investing platform they consider. (In other words, they can “underwrite the underwriter.”)
The most important thing to consider in your own underwriting:
- Know who you are investing with: take the time to understand the track record and experience of the GP on the investment.
- Make sure you understand the risks, and feel comfortable with the level of potential return versus those risks.
Underwriting measures, risk factors, and due diligence steps are all documented in offering materials of each EquityMultiple investment. Should you have questions at any time, Investor Relations is standing by and can be contacted at ir@equitymultiple.com or via the chat feature in the platform.
FAQs on Underwriting in Real Estate
Q: What is underwriting in real estate?
A: Underwriting in real estate is the process of evaluating the creditworthiness of borrowers and the viability of properties to determine the risk involved in a loan or investment.
Q: What is the primary purpose of underwriting in real estate?
A: The primary purpose is to assess the creditworthiness of borrowers and the value of the property, ensuring the investment is secure and financially viable.
Q: How does underwriting affect real estate investment decisions?
A: It provides a detailed analysis of the investment’s financial health, helping investors make informed decisions and minimize risks.
Q: Can investors perform underwriting on their own?
A: While investors can conduct their own analysis, professional underwriting involves complex evaluations best handled by experienced underwriters or through platforms like EquityMultiple that offer vetted investment opportunities.
Q: What factors do underwriters consider in their evaluation?
A: Underwriters consider factors such as debt-service coverage ratio (DSCR), rent growth, vacancy rates, cash flow forecasts, and potential returns to evaluate the investment’s risk and viability.
Q: Why is underwriting particularly important in commercial real estate investing?
A: Due to the higher stakes and complexity of commercial real estate transactions, underwriting is crucial for assessing the financial stability and potential returns of investments, ensuring that investors are making sound decisions.
Q: Can underwriting guarantee the success of a real estate investment?
A: While underwriting significantly reduces risks by providing a thorough assessment, it cannot guarantee success due to external factors like market fluctuations and unforeseen events.
Q: How does EquityMultiple approach underwriting?
A: EquityMultiple employs a conservative yet strategic approach to underwriting, focusing on meticulous evaluation and due diligence to identify and mitigate risks, aiming to exceed investor expectations with high-performing projects. Notably, EquityMultiple features in-house underwriters who vet potential investments across a number of factors and conduct sophisticated modeling and analysis when making determinations about potential investments. EquityMultiple also employs an in-house asset management team that works to maximize returns and anticipate risk throughout the lifecycle of an investment, which may include re-underwriting investments mid-stream.
