Pre-Underwriting Helps to Sell Properties
Residential homebuyers often get pre-qualified to facilitate their negotiating and purchasing process. Commercial property brokers can use a less-common but similar process for their income-property listings — although it's the property that gets pre-qualified, or pre-underwritten, rather than the buyer.
Typically a broker's initial financial analysis shows a bottom line, or net operating income, that is different from the figure on which a lender bases a loan amount. Frequently, a lender comes up with a loan amount that is lower than the buyer anticipated. In purchase contracts that are subject to financing, which is fairly standard, the buyer may try to renegotiate the price, and the deal could be delayed or fall apart.
Enhance Marketing Packages
Most marketing packages for income-producing properties contain financial information such as a pro forma of the property's annual cash flow based on actual historical expenses or projected operating costs. More sophisticated analyses may provide a net operating income scenario over a five-year to 10-year period and show expected profit based on an anticipated sales price. Such analyses are valuable in showing prospective investors the return that can be expected under the particular scenario portrayed.
But even many of the more sophisticated analyses often don't include certain aspects of the property's operation that are an integral part of the underwriting process. Even those analyses that take into account tenant fit-up expenses, leasing commissions, replacements, and other amounts set aside for reserves — collectively called carve-outs — don't allocate or weigh such income-reducing items in a manner that accurately evaluates a property from an underwriting standpoint.
While preparing marketing packages, commercial real estate professionals can seek a cooperating lender that is willing to pre-underwrite a property. (Because this is a relatively new concept, it's hard to gauge how easy it is to find willing lenders in all markets to provide this service.)
Brokers' time involvement is minimal, simply providing income and expense information — typically three years' worth — to the lender. The lender then crunches the numbers and delivers the loan amount and terms.
The lender can provide the broker with a spreadsheet underwriting analysis and a conditional term sheet. In essence, the term sheet is a contingent commitment that the lender will provide a certain amount of financing for the property under specified conditions. The spreadsheet and term sheet then can be included in the broker's offering memorandum as available financing. Thus, the lender gets exposure to prospective buyers in the marketing package.
The pre-underwriting process gives the listing broker two distinct but related benefits.
First, it tells prospective buyers how much financing potentially is available for a property. If investors know upfront that they reasonably can be assured of obtaining a satisfactory loan amount and rate, they may have a more positive outlook while evaluating the property.
Second, the pre-underwriting process validates the asking price. The underwriting process uses a market capitalization rate to determine a property's value. The rate comes from market data sources — most typically appraisers in the property's market — that catalog cap rates and other market data.
For example, using a market cap rate, if a property's income will not support a loan of 75 percent of the property's asking price, the property probably is overpriced for the market. Thus, if pre-underwriting reveals that available financing, as determined by conventional underwriting standards, is substantially less than the target 70 percent to 75 percent, it reasonably could be construed that the listing price exceeds the property's real value.
This information can be a great advantage for brokers negotiating listing prices with owners who think their properties are worth significantly more than the actual value.
Pre-underwriting also can be used to evaluate an undeveloped land listing. For example, if a commercial real estate practitioner were marketing a tract of land zoned for multifamily use, the marketing package would include a conceptual analysis for apartment construction showing the number of units that could be built on the site. By multiplying the per-unit construction cost by the total number of buildable units and adding the land cost, an estimate of the total project cost could be calculated.
By factoring in additional data on areas such as market vacancies, lease-up times, and incentives, a reasonably good evaluation of the project's feasibility can be determined through the pre-underwriting process. Because construction costs and vacancy data can be determined with a fair degree of accuracy, the failure of the underwriting to produce a market financing deal may reveal that the asking land price is too high.
By partnering with a lender for pre-underwriting, commercial real estate professionals may be able to reduce the on-the-market time for their investment listings, obtain offers with tighter financing-related contingencies, and enhance the odds of closing the sale.