Three Underwriting Assumptions to Include in Your Analysis
In case you didn’t know, Underwriting is known as the backbone of investment decisions in the commercial real estate world. It’s the process of establishing both the risk and potential return of all types of real estate investments. Underwriting is used as a tool for evaluating the value of a building based on its projected cash flow. Investors will underwrite, or “model,” the prospective investment in order to forecast the return that can be expected if the investment is pursued.
Here are THREE important financial assumptions to include in your analysis:
While every investor’s goal is to have their property 100% leased or occupied at all times, most understand that a vacancy is likely to occur at one point or another. Banks, loan officers and underwriters account for this while analyzing property cash flow and financials by including a vacancy factor, even if the property is or has been fully occupied in the past. Standard vacancy assumptions vary depending on market conditions, but we have found that an allowance between 5% and 10% of gross rents is a standard underwriting assumption.
2. MANAGEMENT FEE
Hiring a property management company is a must for commercial real estate owners, unless you self-manage your portfolio. The management fee charged by these companies is typically between 3% and 7% of total gross rental income, dependent upon the subject property’s asset type. Even if the property is self-managed, loan officers and underwriters will include a management fee or expense as an underwriting assumption to cover the costs in the event of a default.
An easy way to think of “reserves” is as your emergency fund for the property. This is also another underwriting assumption that is often used by loan officers and underwriters to account for any unexpected costs or expenses. The reserve allowance is typically between $175 and $250 per unit for multi-family assets and between $0.15 and $0.25 per square foot for office, retail and industrial assets. The assumptions are usually on the higher end for older properties because they tend to have more unforeseen expenses or costs.
When it comes down to it, the underwriting process is a key step and can be a deciding factor for whether a real estate property is purchased or refinanced. So unless you are a real estate expert and have experience with financial modeling, trying to tackle underwriting on your own can be an almost impossible task. The smallest error can have a large impact on the accuracy of the projections and result in expensive consequences.
So, if you’re that confident in your skills – Thumbs Up to You! Otherwise, using a professional to handle the underwriting process for you is highly recommended.
Evan Boles is a Financial Analyst with Progress Capital and is experienced in evaluating and underwriting all commercial loan types. He can assist in evaluating potential investments and build an investment model for you while walking you through the analysis. Evan is available to assist you with any commercial lending questions you may have.