Costs of CRE Underwriting Mistakes
Introduction & Research Strategy.
Although there are many opportunities for error in the commercial real estate (CRE) underwriting process, some of the most common mistakes include not underwriting existing tenants, not understanding the lender's preference for third-party reports, and assuming a property has no issues and is code compliant. These issues lead to large losses of money in both the immediate and long-run. In order to understand these mistakes, an explanation as to what each of them are and the impact that they can have on the CRE buying process have been detailed below. Each of these mistakes was determined to be one of the most common because they were mentioned across multiple CRE sites as key issues to address in the underwriting process. Also, as requested, the initial findings from the first hour of research have been included below, so as to have the entirety of the research on this topic within a single place.
- Capital Buffer — "a set of measures taken to ensure that banks have an additional layer of usable capital that can be drawn down when losses are incurred"
- Capital Loss — "the loss incurred when a capital asset, such as an investment or real estate, decreases in value"
- Delinquency Rate — "the percentage of loans within a financial institution's loan portfolio whose payments are delinquent"
Commercial Real Estate (CRE) Losses
- According to the Federal Research Economic Data (FRED) database, the delinquency rate on commercial real estate loans in the U.S. was 0.67% in Q4 of 2019.
- At the end of December 2019, FRED also published that there was approximately $2,319,564,400,000 out in commercial real estate loans in the U.S.
- Based on the above values, this means that about $15,541,081,480 is lost due to CRE loan delinquency. ([$2,319,564,400,000] * [0.67%] = $15,541,081,480 lost from delinquency)
- Mistakes such as not doing due diligence, implementing an exit strategy, and not underwriting existing property tenants are all major issues that can lead to lost money.
Mistakes in CRE Underwriting
Not Double Checking and Underwriting Existing Tenants
- It is vital that underwriters ensure that they carefully look over the existing leases and financial standings of any existing tenants within the CRE they are looking to take over. Not doing so can result in a loss of funding to non-payment, delinquency, or even lease breaks.
- Not underwriting the existing/current tenants of a CRE property can result in a major decrease in property value and income potential.
- By underwriting tenants into a CRE deal, it provides the buyer with instant access to their credit reports without tenant approval, making it easier to screen them and streamline the application/approval process.
- Not underwriting existing tenants into a CRE contract can also cause issues when it comes to determining the new lease rent and alternative revenue streams, such as from parking, amenities, etc. By writing them in, buyers can feel confident in their ability to have tenants that will meet the requirements they plan to implement in the future.
Assuming Lenders Will Accept Any Third-Party Reports
- A very common mistake made by CRE underwriters is making the assumption that lenders will accept third-party reports, including Environmental, Property Condition Assessments, etc.
- By not double checking what reports a lender will and will not accept, a CRE buyer may have to pay for these types of reports twice over.
- As a rule of thumb, CRE buyers should opt to check with their lenders for recommendations for these reports/appraisals, or even see if the lenders want to conduct them themselves. This saves both time and money in the end.
- On average, Environmental Data Records for a property cost about $500, and Environmental Site Assessments cost between $1,500 and $5,000. To avoid having to pay these fees and others twice over, buyers should make an effort to see who lenders will approve third-party reports from prior to getting them done.
Assuming a Property is Code Compliant
- When CRE underwriters assume that a property is code compliant and fail to get an inspection done beforehand, it can cost piles of money in the long run.
- Assuming that a property is code compliant also means that either no documentation was received from the seller, and/or that whatever information was obtained was taken and regarded as true and up-to-date, including adherence to building code, structural requirements, environmental requirements, tax laws, occupancy, and more.
- Taking a seller's word for the state of their building and assuming that they have honestly disclosed all information is poor practice, as they are not obligated to disclose every issue in their building during the selling process.
- Fines for a building violating codes range anywhere from $5,000 to hundreds of thousands. By ensuring that a property is up-to-code prior to buying and having it written into the deal, buyers can save thousands.