Real Estate Underwriting: How it Works

Investing in commercial real estate is an excellent way to diversify the portfolio and earn passive income. However, it’s important for investors to understand the numbers behind the deal, so let's dive into underwriting and see what it’s all about.

Investing in commercial real estate is a great way to earn passive income and to diversify your portfolio. That said, it can be daunting for the first-time investor. In fact, it can also be intimidating for someone who’s invested in dozens of deals! Many one-off developers and project sponsors routinely tout their ability to generate double-digit returns for investors. Sorting through who’s legitimate and who’s not is no easy task. There are many factors to consider beyond the nature of the deal itself. The opportunity might be reliable, for example, but unless it has an experienced sponsor to execute the development plan, actual returns may prove lackluster.

In this article, we look at how to analyze various commercial real estate deals. Specifically, we dive into what sort of underwriting is necessary. Understanding the numbers behind a deal is crucial for any investor—experienced or not.

Related: An Introduction to Office Building Investing

What is Underwriting in Real Estate?

When people refer to “real estate underwriting,” they’re usually talking about one of two different things: the first is the process by which a sponsor and individual investors evaluate deals. In this instance, the term is used broadly to describe the vetting process when looking at any deal.

The second use of the term “real estate underwriting” is more technical, and refers to the process a lender uses to determine the creditworthiness of a potential customer. A lender will typically do a preliminary screening of the borrower’s credentials, such as its experience, equity contribution, and the deal’s anticipated debt-to-income ratio. Most banks will start with this pre-screening before sending the package to their underwriting department for a more thorough review. It is through this process that a bank determines whether it’s comfortable moving forward with the deal, in which case it will then issue a term sheet as part of the full underwriting process.

Feldman Equities can turn undervalued real estate into upscale profit

The Preliminary Vetting Process

As indicated, both investors and lenders will typically do some preliminary vetting of sponsors and the deal under consideration. That process typically looks at the following:

  • Sponsor credentials: A real estate sponsor is the person or team of people who manages all aspects of the project through to completion. This is the team running the day-to-day operations of a project, from site acquisition and entitlements through design, construction, lease-up, and eventual disposition. The sponsor’s credentials are the first thing to consider when vetting a deal. Debt and equity investors are putting tremendous faith in the sponsor, so they must be sure that the sponsor can execute the proposed business plan accordingly.

Questions to consider when evaluating a sponsor’s credentials: How much experience does the sponsor have in the local market place and with that asset class? What is the reputation of the general partners? How has this team weathered economic downturns (if at all)? Who else is on the sponsor’s team, and what experience do they bring to the table? How have the sponsor’s deals performed in the past?

  • Sponsor-provided projections: The next step is to look at the sponsor-provided return projections. In order to understand the projections, you’ll want to dig into the numbers in more detail. What is the sponsor indicating for return projections? Do these numbers seem reasonable relative to current market conditions and comparable projects in the area? As a general rule of thumb, investors will want to apply a discount to the sponsor-provided projections. One strategy is to use the sponsor’s “worst-case” scenario and assume that’s the best-case scenario for your underwriting. Can you live with the worst-case scenario returns? If not, this might not be the deal for you. Any profit generated above the worst-case scenario would be the icing on the cake for investors who ultimately decide to move forward.
  • Pro forma estimates: Anyone who’s investing in commercial real estate will want to be comfortable flipping through a sponsor’s pro forma. The pro forma, usually presented in a spreadsheet format, outlines a property’s assumed income and operating expenses in detail. Depending on the nature of a deal, it might also include a detailed breakdown of hard and soft costs – this is generally applied in development projects, either ground-up or projects with a significant value-add component. Those investing in an otherwise stabilized deal will have a simpler pro forma to consider. In any event, an investor will want to stress test the sponsor’s pro forma estimates to be sure the numbers they’ve presented seem realistic given current and potentially changing market conditions.
  • Floor Plans: Some investors want to take a detailed look at the proposed floor plans for a building. These are helpful, particularly for investors who wish to familiarize themselves with the property. Floor plans can be more or less conducive to tenants in the marketplace and, therefore, can have an impact on overall rent projections. But floor plans can be changed, and as such, should be considered alongside many other factors, including local demographics, the property’s age and condition, location, proximity to major employment centers, and much more. You’ll also want to factor in projected expenses and remodeling, mainly if changes to the floor plans will be necessary to reposition the property effectively.

Related: The Radical Officectomy

The Secondary, Detailed Vetting Process

City Center

As mentioned above, once an investor (equity or debt) has completed its preliminary underwriting, it will want to go through a secondary, more detailed vetting process. This process typically includes the following:

  • Site visits: A site visit will provide the investor with more information about the property’s condition and location. An investor will be able to observe first-hand what improvements are necessary to achieve the projected rate of return. Site visits can also help investors differentiate between Class A, B, and C properties. Site visits are an excellent opportunity for investors to get comfortable with the neighborhood, as well. Site visits provide information about access, proximity to amenities, local demographics, potential crime, and more. Investing in commercial real estate requires a significant capital contribution. Site visits are critical in terms of helping people become comfortable with a deal before investing.
  • Comp prices: Just as someone buying a single-family home would want to know what other area homes are selling for, the same is true in commercial real estate. Investors will look at comp prices to determine the value of the deal before them. The subject property will be evaluated relative to comparable properties in the sub-market based on several variables, including rents, occupancy, unit sizes, amenities, and others.

It can sometimes be difficult to find relevant comps depending on where the investment is located and the property type. For example, there may only be one 150,000 square foot office building in a given market. There may not be another for 10 or 15 miles, in which case the demographics or other local economic conditions may vary, thereby requiring an adjustment to the comp prices (upward or downward) based on those market-specific considerations.

  • Legal compliance: Any time an investor is looking at a deal, he will want to be sure the property is in full legal compliance. For example, a lender in a ground-up development deal will want to know that the property has been fully entitled, meaning it has the zoning and permits in place needed to execute on the sponsor’s vision. An investor may also want to do a title search (or ask the sponsor for a copy of the same), which will confirm that the seller has title to the property and, if so, that the title is clear of any liens or other claims against it.
  • Tenant payments (on time or delayed): A key component of commercial real estate underwriting is to evaluate tenant payments, in terms of both the amounts tenants are paying and when. Many underwriters will audit leases to determine how much income the property will generate, for how long, and how consistently. A lease audit will verify lease amounts, dates, and signatures. It will provide valuable insight regarding cash flow and the potential liabilities that could influence a project’s overall projected rate of return.
  • Appraisal: Most commercial loans require the borrower to get an appraisal. An appraisal determines the value of a property based on market comps, cap rates, and net operating income. The report will be completed by a third-party selected by the underwriter. If the sponsor disagrees with the appraised value, they can challenge it and request another to be paid out of pocket. The lender will then usually take the average of the two appraisals when determining value.
  • Occupancy history: A property’s occupancy history is critically important in terms of underwriting. There are a few ways to look at occupancy. For a property that is more or less stabilized, the current occupancy is indicative of how a property will perform. A value-added investment may have unusually low occupancy, so in these situations, the investor will want to look at the going-in occupancy rate (upon purchase) and stabilized occupancy rate (the occupancy rate assumed once value-add investments are complete). In ground-up development deals, investors will look to market absorption averages to project a realistic occupancy rate for the project under consideration. One common mistake investors make is not factoring an appropriate level of vacancy. Even in the strongest of markets, there will be occasions where spaces sit vacantly. In markets with exceptionally low vacancy rates, investors will want to carry at least a 5% vacancy rate in their underwriting. In markets with higher vacancy rates, carrying 10% to 15% may be more appropriate.
  • Pro-forma financial analysis: The pro forma financial analysis is perhaps one of the most critical aspects of the underwriting process. As indicated above, a pro forma provides a detailed, line-by-line estimate of projected and actual revenues and expenses. The accuracy of a pro forma is critical as it determines the rate of return that investors can expect. Investors will want to take a conservative look at the sponsor’s pro forma. All numbers should be stress-tested to ensure that they hold up even if market conditions change. Those who are uncomfortable analyzing these numbers may want to engage a financial consultant or other advisors to help explain the deal before investing.
  • Budget analysis: With the pro forma in hand, an investor will then want to start crunching the numbers. What is the property’s net operating income? How much does the property generate in cash flow today vs. what will it make after property improvements? More importantly, investors will want to understand how those numbers impact their potential returns. Investors often look at cash-on-cash returns when underwriting a deal. This helps provide insight as to a property’s true value.

To calculate cash-on-cash returns, use the following calculation: cash-on-cash return = annual pre-tax cash flow / total cash investment x 100%.

An alternative way to crunch the numbers is by looking at the property’s “cap rate.” This is a formula that is used to estimate the potential return an investor will make on a property. A cap rate is expressed as a percentage, usually between 3% and 20%, though it can be higher or lower. Cap rates have an inverse relationship to the property value; the more valuable the property, the lower the cap rate and vice versa. A detailed pro forma is needed to help calculate the cap rate.

Feldman’s Underwriting Philosophy

Feldman is a longtime sponsor of value-added real estate deals in the Tampa Bay area. Our underwriting philosophy always errs on the side of conservative. We’d rather under-promise and over-deliver, generating returns for our investors higher than they’d initially anticipated. Ultimately, we find that this approach helps us broaden our network. Our investors, having realized “surprise on the upside,” they tell their friends about what a great investment opportunity they got into, and their friends then approach us about investing in future opportunities. It’s an approach that has helped us grow over time while maintaining a best-in-class reputation.

Why Meticulous Underwriting is Important

Morgan Stanley Tower

It’s essential to have both conservative and meticulous underwriting. As a sponsor, we take a first pass at putting together realistic numbers for our value-add deals. We then pass these numbers along to investors and lenders for further vetting. We are careful to account for any potential cost, including all capital improvements and tenant improvements. We build in a healthy contingency in the event of unforeseen expenses. This level of detail is what ultimately translates into high-performing projects that meet (and often exceed) the returns as pledged to investors.

Meticulous underwriting is especially important when trying to attract capital to a deal. All investors want to have full faith in the numbers before them. They’ll want to be sure that they can live with any potential downside scenario, which is why it’s important to stress test numbers before setting out to raise funds. It is through these numbers that an investor determines what level of risk to assign to a deal, or in the case of a lender, how much debt to provide and at what terms. The more detailed the underwriting, the more confident your partners will become with the transaction.

Need help turning around underperforming property through extensive renovation, aggressive promotion and lease-up? Contact Feldman Equities today.


It is easy for investors to get excited about a specific opportunity. A sleek set of marketing materials can overshadow the actual numbers behind a deal, which, when investigated in more detail, might prove that the deal is more lackluster than the prospective investor had expected. This is why a multi-step underwriting process is so crucial to any deal: no investor should blindly trust a real estate sponsor. Instead, investors should carefully vet all numbers. What are the project’s most significant risks? Has the sponsor accounted for those risks, and how? Before making a substantial investment, it is crucial to understand all aspects of the business plan – from the sponsor to its underwriting – to minimize risks and maximize potential returns.

Related: Commercial Real Estate Jargon Explained

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