A typical real estate transaction has so many moving parts, it can be easy to get lost in the details. Amid market fluctuations, advances in technology, and changes to the homebuying industry, today’s investors are required to pay extra attention to make sure nothing falls through the cracks. In this article we will answer the question of what is underwriting in real estate?
One part of the underwriting real estate transaction process exists specifically to help investors (and lenders) avoid potentially risky deals. Read through the following guide before you approach your next deal and learn how to make the best use of underwriting real estate.
What is Real Estate Underwriting?
Real estate underwriting is the process of reviewing a loan application to determine the amount of risk involved. The underwriter will look at the borrower’s financial standing and the value of the property at hand to review the potential of the deal. Underwriting is a crucial part of the transaction process as it can help both investors and lenders bypass unsuccessful properties.
Simply put, real estate underwriting can be thought of similarly to the pre-approval process for a loan. Both analyze a borrower’s finances to determine the viability of a deal. The difference is that underwriting specifically considers the level of risk involved, and in many cases, requires extra information from the borrower. Lenders do not always require this comprehensive process, so many investors will learn how to underwrite a deal themselves (with the guidance of a financial advisor).
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Definition of Underwriting
The underwriting definition is the process of accepting liability when an investment is made and guaranteeing payment in the event of loss or damage. Underwriting is not exclusive to real estate and can be used for any loan, investment, or insurance. According to Investopedia, underwriting originated from a practice where investors would leave a signature under the amount of risk they were willing to take on in a given deal. While the process is much more formal now, the name underwriting is still associated with this type of risk evaluation.
What Does A Real Estate Underwriter Do?
An underwriter’s role is to research the borrower and investment to determine the security of a loan. One of the main factors they will look at is the debt service coverage ratio (DSCR). This metric is calculated by reviewing the net operating income of an investment in relation to the total loan amount. Essentially, this will reveal if the profits made from the investment will be enough to repay the loan. The underwriter will use this information and a few other factors to determine whether or not a loan should be approved.
Further, underwriters are responsible for making sure there is enough collateral securing the potential loan. Most real estate loans will use the property as collateral, meaning the lender could seize the property in the event of default. For the real estate underwriter, this involves confirming that the property value does not exceed the loan amount. The underwriter will use the appraisal amount to evaluate the size of the loan. The underwriter will likely not approve financing if, for some reason, the loan exceeds the appraisal value of the property,
Factors to Consider
The underwriting process will consider some main factors to determine the strength of the investment opportunity presented. If the following conditions of your investment are met, it will most likely be considered low risk.
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Rent Growth: The underwriter will consider the current amount of rent the property will generate as well as factors that will influence the future rent prices of the property. This can include the market’s seasonal trends and economy and job growth in the area that will affect the supply and demand of the rental market.
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Vacancy Rate: Similarly, the vacancy rate of the property will also be taken into consideration. A single-family home will have a 100% vacancy in the period between a tenant moving out, repairs being made, and a new tenant occupying the property. However, a multifamily property will still generate income from the other tenants on the property.
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Cash Flow Forecast: The rent growth and vacancy rate will inform the underwriter of the cash flow of a property. The property’s net cash flow will consider how much money a property will generate and subtract and costs associated with repairs and maintenance. The higher the net cash flow, the lower the risk of the investment.
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Potential Returns: Underwriters will take the potential return on an investment property. Essentially, the property will be evaluated to determine if it will generate more money than what will be spent on it. The higher the returns, the better the investment.
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How Does Underwriting Real Estate Work?
The real estate underwriting process can start one of two ways: when an application for a loan is submitted or when an investor decides to complete the underwriting for a potential deal. The purpose of underwriting is to evaluate the applicant’s financial integrity, and typically touches on four areas: income, credit, asset information, and the home appraisal.
Income
In terms of income, the underwriter will determine whether or not your income is enough to cover your mortgage payments. Expect to provide documents that prove your monthly income, such as your most recent W-2s, pay stubs, and bank statements. They will also determine your credit worthiness. A strong credit score demonstrates to the lender that you’re more likely to pay back your debts and help you qualify for a lower interest rate. Although lenders require different credit scores based on loan type, the minimum score is in the range of 580 and 620. Debt-to-income ratio is another important indicator that they’ll look at.
Assets
Your assets can also help you qualify for a mortgage. The underwriter will evaluate the value of your assets, which can be sold for cash in case you begin to default on mortgage payments. Checking and savings accounts, real estate, stocks, and personal property are examples of personal assets. Last but not least, a property appraisal is almost always required. By conducting a property appraisal, both you and your lender will have peace of mind knowing that you’ll only borrow enough funds to cover the home’s actual worth. This also process also helps to keep seller honest.
Timeframe
A typical underwriting process can take anywhere from a few days to a week to complete. The longest portion will be making sure the necessary paperwork is promptly submitted. Any borrowers hoping to speed this up should prepare the required documentation in advance and should be responsive to any communications from their lender. The final step in the process is the decision and the review of any approval conditions.
Who Can Use The Underwriting Process
The real estate underwriting process can also be completed by real estate investors looking to evaluate deals themselves. This involves reviewing the property numbers through a careful deal analyzer. Factors to look at include net operating income, return on investment, and more. Investors who opt to underwrite their own deal will then have it reviewed by a third party (typically a broker or financial advisor). Next, investors will anticipate possible scenarios and plan potential reactions and outcomes. To be clear, underwriting real estate yourself is not a way to get approved for a loan. Instead, it is another tool that can be used to evaluate risk in a potential deal.
Do you have a strong deal analyzer? Double-check your numbers using our rental property calculator, here.
Pro Tips For Improving The Underwriting Process
The underwriting process can be stressful for homebuyers and investors alike. It typically involves a lot of waiting, and can take a little while to complete. Here are a few tips to improve the overall experience and avoid any bumps along the way:
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Be clear in your application: It’s important to be as clear as possible when applying for a loan. If they ask for information, give it to them. This will help the underwriting process exponentially.
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Don’t lie about your income: Another key point to remember as you apply for a loan: be honest! Do not stretch the truth about your finances because your lender will find out — and it will only make the process more difficult.
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Be available for questions: Pay attention to your phone and email during the underwriting process. If someone reaches out for a copy of a tax document or clarity about a bank statement, be ready to answer as soon as possible. This will help keep the process on track.
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Wait before applying to other loans: Do not open any new accounts, credit lines, or more during the underwriting process. This will only complicate the underwriters work, and in some cases it can effect your eligibility for the loan.
Summary
Hopefully by now your question of what is underwriting in real estate has been answered. As investors seek to adapt to the changing real estate industry, it can be easy to overlook the smaller features in any given deal. However, dedication and strong attention to detail are what distinguish savvy entrepreneurs from their peers. Before you approach your next property, whether it be residential or commercial, familiarize yourself with the underwriting real estate process. This process can help you avoid potentially risky investments and find successful additions to your portfolio sooner.
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