If you’ve been through any type of training on commercial real estate underwriting, you’re probably familiar with the basic accounting and mathematics that go into underwriting a commercial property. You don’t need me to tell you that you calculate an NOI by subtracting operating expenses from the EGI, or that you convert an NOI to a price by dividing the NOI by the cap rate.
Underneath all of the numbers, though, underwriting commercial real estate is a much more artistic process than it seems. Just about every number that you underwrite represents an opinion as much as a fact. For example:
- Should you underwrite with a property’s current insurance rate or with the rate it will be after it changes hands at a higher value?
- If an owner just replaced an old 80 AFUE furnace with a 97-rated unit, should you use the old gas bill, use the projected new number, or choose something in between?
- When tenants have rent bumps, do we include the rent they paid, the rent they will pay, or an average of both?
All of these are judgment calls and, especially in the world of privately-owned investment real estate, the answers aren’t always clearly defined. Instead, it becomes a test of your judgment as a commercial real estate Advisor and as a market expert.
Taking this more fluid view of underwriting commercial properties lets you add more value for your clients. If you always take trailing 12-month expenses, for instance, you might miss out on the benefit of upgrades to a building. Knowing how to flex your standards to conform to market realities could let you add more value for your clients. And doing that lets you land more deals.
The key to doing this is to treat CRE underwriting as a collaborative process. The old model of getting numbers from your client, going back to your office to do a financial model, then presenting a written report is obsolete. Even if you’re still using paper-based presentations, your most important tool is now a pencil. That way, you can talk through the building’s financials with the owner and, as appropriate, change your assumptions to better reflect the truth at the property. Frequently, this process will lead to higher NOIs and higher selling prices. Along the way, it also positions you as a partner and Advisor, making it more likely that your prospect will have enough comfort with you to become a client.
So, brush up your underwriting skills and learn how to do it on the fly. Knowing this – and being able to clearly translate your business assumptions into marketing text that prospective buyers can understand – will make you a more effective listing agent.
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