What is UNDERWRITING in Real Estate?

Today, I’ve decided to do a deep dive into the art of underwriting, which helps investors determine whether or not a deal is great. So, what exactly is underwriting in real estate?

It seems that you guys are wondering the same thing. 

The other day, I received one of the BEST questions from a reader named Levi.

"Could you please talk in-depth about the most vital research to do on a deal, so you can potentially pitch your deal with more certainty to lenders and co-signers?"

So Levi, as you might know by now, I’ve never lost money on a deal in all my 35+ years of real estate investing.

That’s because I use a strict set of criteria to analyze and choose my deals – and yes, there is an art to it.

So, what is underwriting in the context of real estate?

In real estate, underwriting is the process of vetting a property, its income, and its expenses thoroughly to determine whether it will be profitable.

It takes place AFTER you’ve found a GREAT property… 

And BEFORE you make an offer, do further due diligence, and secure financing.

This process helps me know exactly WHEN to make an offer, and when to simply walk away.

You need to have all the data so you can potentially make your offer with confidence. 

This could also help your investors feel comfortable about the deal. 

And since you’re the number 1 investor on this real estate deal, your underwriting helps you sleep soundly at night.

You’ll know that you’ve personally underwritten this deal, you haven’t taken any shortcuts, and you know what you’re doing.

And as you’ll see later, this research is how you potentially pitch your deal with certainty to lenders and co-signers.

"Also, can you go over a deal on the whiteboard without using any real estate lingo? Because I feel like it would open my eyes just that much more. Can’t wait to make a deal with certainty and confidence. Thanks again, Grant + team. What you teach is worth billions."

Well, Levi, you know how much I love helping others get in the game.

That’s why I’m going to explain everything step-by-step in this email, with charts, definitions, and examples.

But I cannot avoid the math and lingo when talking about real estate. You’ll see why in a moment.

So, if you want to find out what I personally do to minimize my risk AND increase my potential profits in multifamily investing… then read on to discover:

⇒ Why I’ve never lost money on a deal… and why underwriting is critical to your success in real estate.

⇒ What GREAT underwriting looks like, step-by-step… and the #1 character trait you need to succeed at it.

⇒ How I know when to pull the trigger on a deal… and when exactly to walk away.

So find a quiet place to sit, grab a pen and some paper, and let’s get started.

MY SECRET TO NEVER LOSING MONEY ON A DEAL

When you find a great deal, it can be difficult to contain your optimism.

BUT BE WARNED: THIS IS NOT A TIME FOR OPTIMISM. 

This is a time to balance between pessimism and optimism… and assume the WORST.

Because if your deal can weather the worst-case scenario, it’s likely you won’t lose money.

If you put your deal through all kinds of worst-case scenarios, as I’m going to show you today, you increase your chances of being cash flow positive. 

This is why I’ve never lost money in an apartment deal. 

So I highly suggest you learn how to underwrite a deal.

It could give you the peace of mind you need… knowing that your property can likely survive all kinds of worst-case scenarios.

It will help you pull the trigger and close a deal with more confidence.

Best of all, you could get a pleasant surprise when your returns are much higher than expected.

HOW I REDUCED MY RISK & INCREASED MY RETURNS

Let me give you an example of a rental property I’ve invested in.

After all my underwriting and calculations, I determined that I would incur about $31 million in closing costs.

But I also knew from my research that I could have gotten my rehab costs down to $300-400 grand, and land somewhere closer to $30.2 million in total closing costs. 

That’s a significant reduction in costs.

But I left my underwriting at $31 million, and I didn’t reduce it by $800 grand. 

Why?

BECAUSE OF RULE #1 OF INVESTING: DON’T LOSE MONEY.

And that’s why I don’t speculate or get overly optimistic in my own real estate underwriting.

I strive to be conservative in my underwriting, without being so conservative that I dismiss every deal that comes my way. (More on this later.)

So in this case, all I wanted to do was make sure that my deal can:

• Withstand the worst-case scenarios. 
• Produce cash flow in the worst-case scenarios.
• Have a clear exit strategy.

And it worked for me. 

I ended up with a deal I loved, and a building I loved in a great location.

Best of all, I ended up with a better return than expected.

Thanks to my careful underwriting, I ended up with a return better than anything most people likely get from a savings account in the bank.

And this return could potentially keep growing as the rents increase.

WHY UNDERWRITING IS CRITICAL TO YOUR SUCCESS IN THE REAL ESTATE GAME

Here’s why the underwriting process is so CRUCIAL to multifamily investing.

1) You’re setting your investment up for potential success.

Underwriting helps you to understand and love ALL aspects of the deal, so you can select potentially GREAT deals and be likelier to pay a fair price.

It’s also how you know if you can potentially achieve your targeted returns, even in worst-case scenarios.

2) You’re more likely to beat your competition and win the best deals.

Remember – you only want to do deals where you have other buyers competing against you.

That’s how you increase your chances of potentially selling your property one day for profit.

But if you want to dominate the competition, you have to show the real estate brokers and sellers how confident and committed you are.

You want to show them you’ve done your homework – so do your underwriting well.

Another thing top multifamily investors do to beat the competition is to go hard on a deal.

This means putting down a nonrefundable deposit to demonstrate confidence in the deal.

And how do we make sure you don’t lose that deposit?

UNDERWRITE YOUR DEAL AS THOROUGHLY AS POSSIBLE.

And always seek the guidance of a licensed professional before taking action. *Please see the full disclaimer below.

3) You’re winning the trust and support of your investors.

Remember, people rarely do multifamily investing alone.

There is strength in numbers.

So if you are pitching your deal to other investors, you need to know with as much certainty as possible that it’s a solid deal.

And they’re counting on YOU to underwrite deals sufficiently and consult professionals before closing a deal.

This trust your real estate investors are placing in you is SACRED, so do NOT half-ass the underwriting process.

Whether you’re learning to be an active or passive investor in multifamily real estate…

Grasping the underwriting process is CRITICAL to your success.

HOW I UNDERWRITE A REAL ESTATE DEAL IN LESS THAN 5 MINUTES

I probably underwrite 2 deals a day… and 700 deals a year.

It’s how I practice and exercise my “deal muscle.”

Because if you don’t keep practicing and looking at deals, you’re never going to buy a deal.

So I do what I like to call “napkin underwriting.”

Now, this is not the FULL process – it’s just how I know quickly if I like the numbers on a deal.

Here’s how I do it:

I take out a napkin or a notepad, and I do a simple calculation that looks like this:

Let’s break this down.

Occupancy Rate: This is the percentage of occupied units in the property. No matter what a broker tells me, I usually keep this figure low to plan for the worst-case scenario. Never assume your building will be 100% occupied.

Expense Ratio: This number tells me the percentage of the property’s income that goes to expenses. I also stay as conservative as possible on this number.

I exclude Other Income for now to keep things simple, especially if it’s an older property.

Once I’ve completed the calculation, I have an ESTIMATE of my annual Net Operating Income (NOI).

I can now use the NOI use to estimate how much to PAY for the deal.

Estimated Purchase Price = NOI ÷ Cap Rate (rate of return)

So in the example above, if the property has a Cap Rate of about 4%, then my estimated Purchase Price would be:

Estimated Purchase Price = $621,000 ÷ 0.04 = $15,525,000

I personally use this calculation to estimate if I’d be paying a fair price for the deal.

So that’s how I underwrite 2 deals a day, each one in under 5 minutes.

But napkin underwriting is NO substitute for detailed and thorough underwriting, extensive due diligence, and getting second, third, fourth opinions.

Let’s see what the full process looks like.

HERE’S HOW TO KNOW WHAT A GREAT DEAL REALLY LOOKS LIKE

The graphic below shows you the different aspects of underwriting a great deal in real estate.

Let’s go into each aspect in detail.

1) You need to gather KEY documents about the deal.

Here are some key documents to request from the broker or seller:

⇒ Offering Memorandum (OM): This document from the broker shows you all the basic information about the property. While you can use this document as a reference point, remember that it is NOT objective. It’s the broker’s sales pitch. 

WARNING: Lazy real estate investors often do their underwriting solely based on this document, and then freak out when their deals make much less money than expected. So don’t be lazy – get all the key information you need, and learn how to underwrite a deal properly.

⇒ Rent roll: This document shows you historical information about every single unit in the apartment building, such as the rents and details about each unit.

⇒ Trailing 12 months of income and expenses (T-12): This is an important document showing you ALL the information you need about the last 12 months of revenue and expenses for an apartment building. Studying this document is critical to underwriting your targeted returns and your purchase price.

⇒ Floor plans: Floor plans help you to see if the living spaces for your tenants actually make sense. You can quickly see if the floor plans feel right to you, and whether there are any odd-looking floor plans in this building.

AS FORMER U.S. PRESIDENT RONALD REGAN USED TO SAY, “TRUST, BUT VERIFY.”

Brokers and sellers can sometimes manipulate documents anyway, so you also need to know the source of the data and documents you receive. 

For example, where did they obtain the numbers for market rents?

And as you’ll see later, documents are only half of the story.

You also need to verify, calculate, and analyze the rest of the deal.

2) You need to examine the property and location in PERSON.

By now, you should have walked several deals and gotten to know the location better.

But no matter how experienced you are, you should always visit the property in person.

This will make brokers and sellers MORE likely to take you seriously.

While on location, ask yourself: 

• Do you feel good in the area? 
• Does it feel safe for kids? 
• Does it feel good in the morning, the afternoon, and at night?
• Do you see parts of the property that you can improve and value-add?

Also, talk to the staff, residents, community members, and the local police. 

Understand first-hand what’s so great (and NOT so great) about the property and neighborhood.

Backup your on-the-ground research with some online research on:

• The housing landscape
• Job market
• Transportation
• Cost of living
• Highway accessibility of the building
• Competitiveness of local rents
• Economic conditions
• Local politics
• Local incomes and credit score worthiness of the tenants
• Competition in the area (other apartment buildings)

Some websites to look at include:

• Local economic development websites
• Local chambers of commerce websites
• U.S. Census Bureau
• U.S. Bureau of Labor Statistics

3) You need to talk to local property management firms.

Regardless of how familiar you are with the real estate market, get the top local property management companies to help you with your underwriting.

They’re likely to help you because it just might become a win-win situation for both of you:

You could win the deal, and they could win a property management contract with you.

You’ll find that they can give you a great second opinion on the following:

• The quality of the property and locations
• Your income and expense projections
• Rehab and property management costs
• Quotes from local vendors and contractors 
• Value-add opportunities to increase revenue and cut expenses

Remember: property management firms also benefit from more doors.

Meaning, the bigger your real estate deal is, the more likely they are to help you with your underwriting.

4) You need to do the math on how much MONEY this property might make for you.

Before projecting your property’s potential income, you need to VERIFY exactly how much income the property is bringing in right now.

This is how you forecast how much income it could create in the future – with as much certainty as possible. 

However, you should know there is no such thing as guaranteed income! *Read full disclaimer below.

You can use a spreadsheet or professional financial modeling software to do this.

The graphic below shows you what the process looks like.

First, look for any unusual income trends.

You can do this by comparing the historical rental income in the T-3, T-6, and T-12 statements to your rent roll.

Some numbers to scrutinize include the current rents, market rent, and other income earned.

If you see any unusual increases or decreases in income over a period of time, talk to your broker or seller and get the full story behind the numbers.

Second, determine a fair price you can charge for future rent.

Visit your competition… and find out what they’re charging for different types of units, and determine your future rents for your potential deal.

By this, I mean looking at other properties with similar units, ages, conditions, and amenities.

Third, you need to account for the property’s losses.

This means you need to know how much income the property is losing.

Know what your Vacancy Loss is, meaning the amount of money you lose due to your vacancy rate.

You also need to know your Collection Loss, meaning the income you lose from tenants who’ve failed to pay rent.

Note: Your property could also be losing income to model units, maintenance or rental offices, and storage units. Look closely to see what else you could be making losses from.

Fourth, determine your Effective Gross Income (EGI).

This is one of the MOST important numbers you need to know in both residential and commercial real estate.

You will use this number to determine the TOTAL amount of real income that was actually collected in the past year.

This will help you see if the deal is currently making money, so you can underwrite your deal with more confidence.

Fifth, you need to budget for your Capital Expenditures (CapEx).

This refers to any one-off expenses you will need to incur for major improvements to the building, such as upgrading units or building a new roof for the clubhouse. 

This affects how much you can increase rents, and what your property’s income could look like in the future.

Finally, project your deal’s income for the next 10 years.

Based on all the data you have uncovered and verified, you can now more confidently forecast your property’s income for the next 10 years in your spreadsheet or modeling software.

Remember to stay conservative.

If you get too optimistic about rent increases and income, it will likely cost you and your investors MORE in the long run.

5) You also need to know how much you might SPEND on this property in the future.

No real estate underwriting is complete without knowing your property’s expenses.

If you want to know if your deal is likely to cash-flow, then don’t skip this part!

Here’s what the process looks like:

First, look for any unusual expenses.

Because expenses fluctuate over the years and can be manipulated by the seller, you will need to see the T-12s from the past 5 years.

You should look for unusual spending patterns in property management fees, payroll for all staff, property taxes, property and liability insurance, utilities, administrative fees, legal fees, accounting fees, maintenance fees, turnover fees, landscaping fees, advertising fees, etc.

Make sure you exclude the interest paid on loans and CapEx. They will be accounted for later.

Use these numbers to calculate your Operating Expenses. This is the total amount of ongoing expenses you will incur from day-to-day operations on the property.

Again, talk to the broker or seller if you notice any missing expenses, unusually small or large expenses, or expenses that are completely unnecessary.

Next, determine your dollars-per-unit and Expense Ratio.

To calculate your dollars-per-unit, you’ll need to divide the total annual expenses by the total number of units in the building.

This helps you to quickly see how your deal compares to other properties and industry norms.

You also want to see your deal’s Expense Ratio.

Expense Ratio = Operating Expenses ÷ Effective Gross Income

This allows you to compare the property’s expenses to its total income.

Be skeptical and wary of expense ratios that are too low.

(Note: I covered Effective Gross Income in the section above on underwriting your deal’s income.)

Third, corroborate with your property management firm’s numbers.

Talk to your property management firm about the expenses you’re seeing. Ask them whether these numbers make sense.

Even though you can compare these expenses with industry reports, they can be unreliable and don’t take into account your deal’s unique circumstances.

REMEMBER: EXPENSES WILL ALWAYS CHANGE IN THE FUTURE.

Your tenancy, your market’s cost of living, the local property regulations, the local weather and climate, and most importantly property taxes, can and WILL change your property’s expenses in the future.

Don’t assume that property taxes won’t change – they almost always increase after closing the deal.

Check with local tax attorneys, the local tax authority website, or the local tax assessor to project your property’s future taxes.

Fourth, project your expenses for the next 10 years. 

Once you’ve studied all the historical expenses, you can project them on the same timeline as your income projections in your spreadsheet or software.

Now you’re ready to determine if your deal could cash-flow!

6) You need to calculate your Net Operating Income (NOI).

This is a VERY important calculation to understand. 

Banks and lenders care about NOI the first time – and you should too.

To get your NOI, you take the Effective Gross Income you determined when underwriting your income…

And then you subtract the Operating Expenses you found when underwriting your expenses.

NOI = Effective Gross Income – Operating Expenses (Excluding Debt Payments)

The higher your investment property’s NOI… the less you could have to pay for your real estate loan… and the more potential cash flow your property could generate.

Later, I’ll talk about why it’s important to think about the future as well.

You should be asking yourself: What will the NOI be 3 months from now? What about 36 months from now?

7) You need to determine how much money you’ll need for the deal.

Now that you’ve underwritten your income and expenses, you’ll likely feel more confident about your deal.

This is the kind of confidence you need to:

A) Know how much money you need for the deal.

B) Bring your deal to lenders and other investors.

You need to have a competitive offer at hand before troubling lenders with the real estate underwriting process.

Here are some critical components to include in your underwriting after talking to your lender:

⇒ Type and duration of loan: 

Interest-only loans: A loan that allows the borrower to only pay interest on the loan, and not pay the principal down.

Principle-and-Interest loans: A loan where you pay for both the main loan (principal) pay down and the interest.

⇒ Interest rate: Money paid regularly at a particular rate for the money you have borrowed, expressed as an annual percentage of your outstanding loan.

⇒ Loan to Value (LTV): This determines the ratio of debt to property value and helps the lender gauge the risk on your investment.

⇒ Loan term: This is the amount of time you have to repay the loan.

⇒ Amortization period: The amount of time over which the loan’s payment is calculated at a certain interest rate.

⇒ CapEx: Any one-off expenses you will need to incur for major improvements to the building.

Make sure T-12 and your underwriting show numbers that meet your ideal lender’s minimum requirements.

Here’s what to look out for:

Use your DSCR and LTV to determine the loan amount you can secure from a lender.

From there, you can estimate how much equity/cash you need to pay for the deal.

This will also help you estimate how much money you might need to raise from potential investors in your deal. 

Remember, the costs of a deal can include:

⇒ The down payment

⇒ Closing and transaction costs

⇒ Lender fees

⇒ Insurance premiums

⇒ Operating funds (before collecting rent)

⇒ Broker commission

⇒ Syndication fees

8) You need to calculate your deal’s potential returns.

Some important ways to look at potential returns:

There are several other ways to calculate returns, and I will talk about them in a future email.

9) You can now determine a fair purchase price.

Once you’ve calculated your targeted returns, you can determine your ideal purchase price for the property. 

This is the price of the property plus all closing costs, legal fees, document fees, financing fees, and costs of any rehab you need to do at the beginning of your deal.

You need to ask yourself:

What is the maximum amount you need to pay to achieve your ideal returns?

Can your bank, your investors, and you pay this amount in the worst-case scenario as well?

10) MOST importantly, you need to underwrite for the worst-case scenarios too.

I underwrite my deals in as many ways as possible.

This is how I’ve personally never lost money in real estate, ever.* 

*Results not typical, please see full disclaimer below.

So when I’m underwriting a real estate deal, I always ask myself: What is the worst-case scenario?

Then I’ll take a legal pad and literally start underwriting different scenarios. 

Some scenarios to account for:

• What does the deal look like with different types of rent increases?
• What if rents never go up?
• What will the deal look like if your expenses increase?
• What if CapEx costs more than expected?
• How low can your occupancy fall before you can no longer pay expenses and loans?
• How will changing interest rates affect your targeted returns?
• What was the lowest performance and NOI in the property’s history – can the property withstand that again?
• What if there are 2-3 years of unfavorable market conditions – can the property handle that?
• What if I pay too much – how do I get out of this property? Can it cash-flow if I overpay for it? (By the way, I personally have never regretted overpaying for one of my deals. I’ve overpaid for most of the best deals I’ve gotten.)
• What if there is no revenue growth in the first 5 years?

You can also use your spreadsheet or modeling software to underwrite for these different scenarios.

Remember, you’re going to be in this deal for the long term, so your underwriting should reflect that as well.

Also, have your lenders and brokers underwrite the deal, then compare it to your own underwriting.

Note that some brokers exaggerate numbers to benefit from the sale, while others are very conservative.

SO ALWAYS GET SECOND AND THIRD PARTIES TO UNDERWRITE YOUR DEAL.

WHEN TO WALK AWAY FROM THE DEAL

If the numbers don’t work in the worst-case scenarios, you need to do more research to find out where the upside is.

Look for other reasons to buy the deal.

Because no number, percentage, or calculation, is a substitute for the most important part of underwriting in real estate: 

Loving the deal. 

So exercise good judgment.

Will you still love the deal at its worst-case scenario numbers?

Otherwise, you need to walk away from the deal. 

JUST HOW CONSERVATIVE SHOULD YOU BE ON A DEAL?

I underwrite EXTREMELY conservatively.

But I know people who are too conservative, which keeps them from seeing the future and buying great deals.

Then there are people who think every deal is a great deal. They underwrite unrealistic rents and expenses.

That’s why I am conservative in my underwriting… but aggressive in my purchase.

This balance helps me to:

• Underwrite my deal more accurately
• Pull the trigger on the deal with more confidence
• Maximize my profit potential

If I’ve accounted for all the worst possible things that could happen to my deal… and I can still find positive cash flow potential…

Then I go for it. I pull the trigger on the deal.

I hope this answers your questions, Levi.

And I wish you all the best in the real estate game.

Be Great,

Grant Cardone