Evaluating any real estate investment is fairly simple. Take the gross annual income, subtract expenses, consider how much the annual debt service and acquisition will cost you, and then decide if the profit leftover is worth pursuing. Next, we will break down the most common expenses you will encounter and how to underwrite these conservatively.
Sourcing a deal is the most time-consuming part of the process. You will most likely underwrite dozens of properties before you find one worth making an offer on. In order to save yourself some time, you need to do a quick, high-level evaluation. The first few documents you will need are the Offering Memorandum, trailing 12-month Profit and Loss Statement (T12), and current Rent Roll. One thing to ensure is that you are getting actual numbers and not a proforma.
Once you have these, you can multiply the current rent roll by 12 to get a gross annual income and subtract the past 12 months of expenses. These expenses will need to be adjusted, but at this point, you only need to worry about adjusting the property taxes as this will usually increase significantly. You should assume the property will be assessed at 75-85% of the sale price. Go to the tax assessor’s website to find out what value the property is currently being assessed at and adjust that number.
After you have done this, you need to determine how much the monthly debt service will cost you. You can download a deal analyzer here. Now you will have a rough idea of the return on investment (ROI) and you can decide if it’s worth digging in deeper.
Confirming Expenses
The next step is to confirm every expense. Ask the listing broker if a recent insurance quote has been completed and, if not, have one done. Start interviewing property managers and determine their fee. Vacancy rate can be determined by the average vacancy of the sub-market the property is located in as well as considering the property’s historical occupancy rate. If delinquency has been an issue, you should underwrite the delinquency from the past 12 months in addition to vacancy.
Repairs and Maintenance (R&M) and utilities are best determined by the property’s historical numbers. Compare the R&M expense to the market average, which your broker or lender will have, and use the higher number of the two. Ensure large Capital Expenditures are not included in R&M.
The most accurate way to underwrite for Capital Expenditures is to determine the remaining usable life for all of the major systems (HVAC, roof, plumbing, etc.). Divide the replacement cost of each item by their remaining usable life and that will give you your total annual Cap Ex budget.
Plug in the numbers for any other reported expense of the property to get a total annual expense and the subtract your total annual expenses from your gross annual income. Gross annual income can be determined by using the T12 financials or multiplying the current rent roll by 12. This brings you to your net annual income.
Debt Service
Do not rely on the debt service quote provided by the listing broker. You will need to get quotes directly from a lender or a reputable mortgage broker. Don’t assume you will only have to put down 20-25% either. Loan proceeds will usually be determined by the Debt Service Coverage Ratio (DSCR) which needs to be at least 1.25. To determine DSCR, divide your net annual income by the total annual debt service. Interest rates can change from the time you are quoted up until closing, so, add 0.25% over the quoted interest rate.
Remember, be conservative in your underwriting.
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