Underwrite Commercial Real Estate in 7 Steps
There is a major difference between residential and commercial real estate evaluation. Residential real estate is valued by comparable property sales. Put simply, a house is worth what a similar house has sold for nearby, give or take for differences. This also applies to rentals if the property is between 1-4 units. On the contrary, commercial property is valued based on property performance. Put simply, if the property makes more profit, it is worth more.
This difference is important because this allows us to focus on property financials instead of property aesthetics. Underwriting any commercial property follows the same path each time, however, in this case, we're going to be underwriting a multifamily apartment building.
Step One - Determine your business plan
The first step in underwriting is creating an initial business plan. This is done by first looking at the property as a whole and devising a plan for it. If the units are outdated, this includes renovations, increasing rent, and possibly separating or billing back utilities.
Step Two - Determine Net Revenue (Current and Proforma)
Determine gross income
-Sum of all rents collected
Subtract vacancy, concessions, plus bad debt
Determine net revenue = gross income - vacancy, concessions, bad debt.
Step Three - Determine Expenses (Current and Proforma)
Repair and maintenance
Snow and landscaping
Management fees (Property management and asset management)
Step Four - Determine Value
Subtract all expenses from net revenue = net operating income (NOI)
Determine local cap rate
Value = NOI / Cap Rate
One of the challenges with determining value is finding the sweet spot of paying what the asset is currently worth versus paying for potential. There is a hot topic depending on who you are talking with. In reality, it's a bit of both. It's better to lean towards the side of current worth, however in the current environment, there needs to be a little give. The trick is to understand the story and the business plan.
Step Five - Determine Debt
Determine annual debt service (loan amount, interest rate, amortization)
Step Six - Determine Cash flow (Current and Proforma)
Subtract debt service from NOI to determine annual cash flow
Calculate return metrics:
Cash on Cash % = Cash flow/ Cash invested
IRR = Use calculator (very difficult)
Equity Multiple = Total proceeds/ initial investment
DSCR = Cashflow / Debt Service
Step Seven - Is it a Good Deal?
Compare to your criteria
Will it hit the desired returns?
Are you being conservative or aggressive in underwriting?
How long will this take?
Will there be enough value to refinance or sell?
Does the business plan make sense?
These are the seven basic steps to underwriting a commercial property. You find in these steps there is a lot of room for estimating. Be wary. It's better to be conservative and have more than enough than to be aggressive and not have enough.