The success or failure of your commercial deal hinges on your ability to underwrite deals accurately. In this video, you’ll discover a step-by-step process designed to help you reduce the risk of bad investments and identify potential problems early on. By the end, you will be armed with the six essential building blocks for underwriting any commercial or multifamily property.
Building Block #1: Rental Income
The first building block to underwriting your deal is to obtain the rental income of the property by getting a current month rent roll and the trailing 12 months of income and expenses.
Rent Roll: A rent roll is a register or list of who the tenants are, what units they occupy, when they moved in, and what their current rents are. The key here is that the rent roll is current; make sure it’s not from three months ago or last year.
Trailing 12 Months Income/Expenses: A T12 is the trailing 12 months of income and expenses, meaning that the income and expenses provided are the last 12 months leading up to the current month. The top half of the page has the income and the bottom part of the page will have the expenses.
Potential Pitfalls
Be sure the seller has provided the “actual” income and expenses. If the rent roll or income expense statement has the words “proforma”, “projected”, or “scheduled”, it means they are not the actual numbers, and you cannot use them to underwrite the deal. If this happens, you will need t go back to the seller or broker and ask for the actual numbers, not just projections the seller and broker put together.
Building Block #2: Operating Expenses
Block number two is gathering the property’s operating expenses and comparing them to the seller’s reported expenses to ensure accuracy. Operating expenses are regularly occurring costs, such as insurance, taxes, repairs, management and landscaping. All of those are operational expenses. It does not include the mortgage or depreciation. Now that you have the seller’s reported income and expenses in the T12, you need to verify the information by comparing the T12 figures to the actual bills paid by the seller. For example, if the T12 shows $10,000 in electrical expenses, verify this with the $10,000 worth of bills.
Potential Pitfalls
The reason why you need to be diligent here is because seller’s sometimes lie. That’s right, sellers lie and may underreport expenses to inflate the Net Operating Income (NOI). You need to be very cautious here because beginners often fail due to underestimating property expenses. When we get a deal under contract with one of our students, our due diligence includes a table of what operational expenses should be for properties in markets across the country. That data comes from doing deals from coast to coast for the last 25 years. So, make sure to get professional help to confirm because your success of failure largely hinges on your ability to verify these figures and accurately underwrite your deal.
Building Block #3: Project Costs
The third step is calculating project costs, which are post closing expenses. Most investors think that after they close their deal, they’re going to begin cash flowing right away. But there are additional expenses, including deferred property maintenance, interior renovations and capital expenditures (CapEx) like roofing, HVAC systems, parking lots, etc. If you don’t factor in project costs when you are underwriting your deal, it could lead to poor cash flow and disappointing returns. Always anticipate additional costs after closing.
Possible Pitfalls:
Paying for these costs from cash flow takes too lone or never happens, so be sure to have the necessary funds available at closing. If you have deferred maintenance, or you want to renovations, don’t rely on cashflow to pay for these things because it takes too long and you’re leaving money on the table. Instead, have it in a bank account so you can start on these items right away.
Building Block #4: Proforma
Building block number four is the calculate the proforma, which is the projected performance of the property. We love value-add deals where we can project a great future with higher cash flow and a higher net operating income because it means an increase in property value. Again, one of the benefits of commercial real estate you can force the appreciation. So, when creating your Proforma, focus on two essential questions:
- Where can you take your rental income in three or five years?
- What is your three or five-year projection for your NOI?
To accomplish your goals, you will need to formulate a value-add plan; move tenants around, renew leases and renovate units to raise rents. Remember, when you raise the rent, you increase the NOI and force your appreciation.
Possible Pitfalls:
For years, when underwriting deals, we have been using an expense increase of 2%. However, now due to inflation, higher property tax, increased insurance costs, and higher labor costs, we are factoring an expense increase of 3% or more depending on the property. Again, these are operating expenses only. And the reason why is because your expenses affect your NOI: The higher your expenses, the lower your NOI. So, when creating a Proforma to project the future rental income and NOI (net operating income) of the property, taking into account potential increases in expenses.
Building Block #5: Financing
Building block number five is how you’re going to finance your deal or your loan. This is the bread and butter of your building blocks because financing affects your cash flow and return on investment (cash on cash return), the two pillars of decision-making. They determine whether your deal is a good deal or a bad deal. Obviously, negative cash flow is a bad deal and positive cash flow means you potentially have a good deal. First you need to decide which financing option you will use. You can go with a conventional commercial loan or use one of the creative financing strategies we teach our students.
Potential Pitfalls:
Whether you get a bank loan or implement more creative financing options, there are key factors to consider:
Loan-to-Value (LTV) or Down Payment Amount: The lower the down payment, the higher your cash and cash is.
Interest Rates: High interest rates are impacting investors, however there is the possibility of interest-only periods which boosts your cashflow and cash on cash return right away.
Amortization Period: When you buy a single-family home, it’s always a 30 year AM, but not in commercial. In commercial real estate, it can range from 15 to 30 years. And the lower the amortization, the lower your cashflow because your mortgage payments are higher.
Balloon Date: Ensure your loan maturity matches your holding period. If you are planning to do a long-term hold for 10 years, but your commercial loan expires in five years, you need to rethink this loan.
Prepayment Penalties: When you buy a single-family home, there’s really no prepay penalty, meaning you can pay it off anytime. However, with commercial real estate there is a prepay penalty. So, if you pay it off within the first year, it’s 5% penalty, the second year you it could be a 4% penalty and so forth. With a larger apartment complex, the pre-pay penalty can be extremely high, making it impossible for you to sell the property and you may have to get the new buyer assume the loan. Knowing what the pre-pay penalty is helps you determine what you can do with your deal moving forward, which leads to building block number six.
Building Block #6: Exit Strategy
The final building block to underwriting your deal is to determine your exit strategy. Your exit strategy is the way you plan to get your money out of the deal. Your strategy for exiting the deal might include:
- Hold the property long-term
- Cash-out refinance and pull out your down payment
- Fix up the property and hold long-term
- Fix up the property and then 1031 Exchange into a larger property to defer capital gains taxes.
Potential Pitfalls
Every deal you underwrite needs to have an exit strategy. Therefore, you must ensure that your loan terms align with your exit strategy, particularly regarding prepayment penalties and loan maturity. For example, if you plan on doing a cash out refi by the third year of owning a property, make sure that your prepaid penalty expires at year three. If not, you will pay a penalty to refinance into a new loan.
These six building blocks offer a solid foundation for underwriting any commercial or multifamily property. They will help you make more informed investment decisions, prevent mistakes, and identify issues early in the process. For further study and deep dives into specific number crunching techniques, watch 3 Simple Steps to Evaluating Multifamily in 5 Minutes and 3 Keys to Buying Multifamily Right. And if you have questions about underwriting your deal, text PETER to 833-942-4516.
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