Written by John Kourafas
One of the most important parts of a commercial real estate acquisition or disposition is the underwriting that takes place during a transaction. Underwriting in commercial real estate is commonly associated with the analysis that investors and real estate professionals use to measure the cash flow, risk, and most importantly, the value of an asset. Real estate professionals and investors will create an analysis that determines the feasibility of each property and its income. Once the NOI (net operating income) is established, the value can be determined.
Underwriting can be complicated, but it is a crucial part of the transaction process. When analyzing a property, accuracy is imperative. If done correctly, an owner or buyer can maximize their value and return, whereas an inaccurate analysis can cost thousands to millions of dollars. Detailed below, is an examination of the three biggest mistakes investors/brokers make when underwriting properties.
- 1. Inaccurate Assumptions
One of the most common mistakes made by investors and brokers when underwriting is inaccurate assumptions in an analysis. When underwriting properties, there’s a significant amount of forecasting and assumptions that need to be made to measure an investment. The more uncertainty in a property, the more assumptions needed in the analysis. It’s easy for investors to be drawn in by a high potential return on a property. Often, we see assumptions with little to no data to support the numbers. However, if the numbers aren’t accurate, you can find yourself upside down in a property after making a substantial investment. Common assumptions in commercial real estate are:
- Market Rent – Applied when filling vacancies or forecasting potential rental growth
- Deferred Maintenance (Capital Expenditures) – Repairs to parking lot, roof replacements, paint, landscape, interior spaces, facade
- Re-Tenanting Costs – Leasing Commissions, Tenant Improvements
- Loan Info – Interest rates, amortization, term, pre-payment fee
- Closing Costs – Escrow costs, broker commission, taxes, attorney fees
The real estate world can move fast and if you’re not in tune with the market, it’s easy for investors to make decisions on inaccurate data that can lead to poor investments.
- 2. Expenses
Failure to account for all expenses and reimbursements is another common mistake that occurs in underwriting. Property taxes are perhaps the biggest operating expense in a property and yet, people still forget to update them in an analysis to reflect the reassessment after a sale occurs. Other common line items that can be impacted by a sale are insurance, management fees, inflation, existing service contracts, and expense reimbursements from tenants. Understanding tenant reimbursements can be complex. It is imperative that each lease is read in detail to understand the current reimbursement guidelines and how this may change after a sale. If expenses are not accounted for properly, this can sway a property’s value greatly.
- 3. Vacancy and Credit Loss
Vacancy and credit loss is the amount of money or the percentage of net operating income that is estimated to not be realized due to vacating tenants or spaces. We see frequently throughout the industry that this is a key component in underwriting that is often overlooked. Common oversights may include general vacancy and credit loss being omitted from an analysis or inaccurate vacancy rates applied but aren’t indicative of the local leasing climates. When an investor purchases a building, the goal is to lease the entire property or maintain its occupancy at 100%. However, it’s inevitable that vacancy will be incurred at some point over the term for a lot of properties. Applying an accurate vacancy rate provides owners with a realistic snapshot of their income over the hold period and account for unforeseen vacancies that may arise.
Consult with an Investment Professional
Underwriting has complexities and requires in depth market knowledge to perform successfully. Consult with an advisor who has comprehensive underwriting capabilities, market expertise, and an understanding of elements that impact value.
John Kourafas, CCIM, is a Commercial Investment Advisor with the Visintainer Group in Fresno, CA. Formed in 2018 and built on a foundation of investment real estate, the Visintainer Group is a client-first commercial real estate firm. The Group has executed over $580 million in transactions across the United States. John specializes in commercial property acquisitions and dispositions for owners in the Central Valley, Sacramento, and Central Coast markets. He can be reached at 559.890.0419 or firstname.lastname@example.org.