Costs of CRE Underwriting Mistakes

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Part
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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.


Helpful Definitions

  • 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.
Sources
Sources

Quotes
  • "1. Inadequate Due Diligence - When conducting due diligence on a real estate property it is important to check the property condition and systems, environmental matters, and structural building components. In addition, be sure to review contract and tax laws, insurance, finance, and accounting, too. Don’t forget to properly assess the local market of the investment property. When checking the local market look at local demographics and trends, population growth, income, employment, traffic, and occupancy levels."
  • "2. Not Underwriting the Current Property Tenants - Investors must underwrite the tenants that are currently at the location. Examine the financial well being of the current tenants by reviewing their financial statements. This will help gain a better understanding of the tenants’ overall business. For the real estate professionals who may not have the time, there are companies that collect this specific information and data as a service."
  • "3. Not Being Over-Leveraged - It is common for real estate investors to borrow money in order to engage in real estate transactions. But beware, there is such a thing as borrowing too much money. This is where having a proper deal structure and investment strategy becomes key. By doing proper due diligence and underwriting, deciding on the adequate amount of money to have in reserves becomes easier. The money in reserve will help protect the investor in the unfortunate circumstance a large tenant moves out or goes bankrupt."
  • "4. No Exit Strategy - Having a strong plan, including a way to exit the investment deal is a sign of a savvy real estate investor. The exit strategy should include an idea of how long it will take, how much money will be made or lost, and how to access the profits."
Quotes
  • "Mistake #1: Improperly valuing the property - Contact active commercial brokers in the area and request an assessment of local property values and sold and listed comparables. Based on that information, adjust your valuation to get an accurate assessment of the property."
  • "Mistake #2: Trusting sellers to disclose any problems - Even if the seller has inspections and reports on-hand, it is always better to have a third-party inspector review the property on your account so you can ask any specific questions and get professional answers."
  • "Mistake #3: Misunderstanding a lender's underwriting requirements - Before the due diligence process even begins, you should make sure you have a discussion with your lenders about the loan amount they will put up on your property. Lenders have been very conservative in recent years and consider several different variables you might not factor in, including intended use and environmental issues. Before moving forward with your investment, you should be sure you understand exactly what your lender is willing to provide and why."
  • "Mistake #4: Assuming the property is code compliant - In addition to having someone inspect your property for unknown problems and damage, you should also have a contractor inspect the facility to ensure it meets all ADA and building codes."
  • "Mistake #5: Assuming your lender will accept any third-party reports - Before you hire a third-party vendor to conduct an inspection for damages or code compliance, make sure your lender approves of them. This includes the Property Condition Assessment, Environmental Report, or any other specialized report you might have done. As a rule of thumb, if you’re not sure if your lender needs to approve of someone, ask anyway."
Quotes
  • "1. Calculating incorrect property values - It’s always safer to be conservative in your valuations of a commercial property. Accurate evaluation of a property requires homework: pull up sales comps, check out other similar properties on the market, and talk to local commercial brokers about local property values."
  • "2. Misunderstanding underwriting guidelines - Before you spend too much time conducting due diligence on any one particular property, it’s a good idea to run it by the lender you plan to request your loan from to find out how much they would consider lending you for it."
  • "3. Not checking whether the property is up to code - have a professional, such as a contractor, inspect the property, looking out for spaces that may have been built out without a permit, to make sure it complies with municipal building codes as well as ADA codes to help you avoid costly surprising after closing."
  • "4. Overlooking nonstandard provisions in existing tenant leases - If you’re purchasing a rental property (retail or multifamily), it’s important to read over the leases for cancellation provisions, contraction provisions, fixed rents, and caps on expenses that can be passed on as all of these can affect the value and income-producing potential of your property."
  • "5. Assuming your lender will accept your third-party reports - ask your lender if they have a preferred appraiser, engineer or inspector that they can recommend so that you don’t have to pay for additional reports later on. Additionally, private lenders will often conduct their own appraisals as part of their underwriting process."
Quotes
  • "1. Improper Site Valuation - Being too aggressive when it comes to underwriting the deal and failure to obtain enough (and accurate) comps can lead to improperly valuing the property. Estimating the value of real estate is necessary for a variety of endeavors, including financing, sales listing, investment analysis, property insurance, and taxation."
  • "2. Misinterpreting Lender Requirements - Lenders consider several different variables you might not factor in, including intended use and environmental issues. Before moving forward it’s important to understand exactly what your lender requires and why. Failing to do so can mean lost time, money, and energy during due diligence."
  • "3. Overlooking What Site Requirements Are Needed - knowing any and ALL requirements that are needed to bring the property up to municipal standards goes a long way in determining the viability of a project. In many cases, some requirements slip through the cracks and create numbing headaches down the road. The later in the project that these requirements are addressed means the more you’re going to have to pay and the longer your timetable will end up being."
  • "4. Assuming Third Party Reports Are OK - Lenders can sometimes require that they give the approval to use third-party vendors for various site inspections. Making the assumption that you can use any third-party vendor or consultant is a common mistake that can add significant cost to a project. Mistakenly having to pay two different vendors for the same report costs much more than time; it is very expensive."
  • "5. Assuming Seller Has Disclosed All Issues - not all sellers are forthcoming about past and/or potential issues on their site. Not digging deep enough into the site’s history is a big no-no. Even if a seller has inspections and reports on-hand, it’s vital to review the reports and inspect the property yourself so you can get the assurance that everything is in compliance. Assume nothing."