3 Ways to Think Like a Lender When Underwriting a Multifamily PropertyPaul Winterowd
Investing in multifamily properties has the potential for great rewards. A critical component of your success will be your ability to secure the optimal financing for your investment. Debt plays a critical role in real estate, and a lot of investors fail to think through the lens of capital providers.
We suggest you take an empathetic approach to how lenders see the world only because it will help you better understand the lending process. If you know how lenders operate, you can get more—and better—debt. That debt will play an integral part in your success as a real estate investor.
1. Evaluate Risk Objectively
A lender’s goal is always to evaluate risk and seek to minimize the potential for loss in an investment. Lenders solve for risk by charging more—the lower the risk, the better the loan’s terms for the borrower. Viewing potential investment properties from the perspective of the lender helps you to evaluate your risk with a more critical eye.
Lenders account for risk with underwriting. Simply speaking, underwriting is the lender’s credit homework. During underwriting, loan officers, analysts and underwriters evaluate all possible factors that may contribute to the viability of a successful investment property.
To evaluate risk like a lender, imagine you are lending money to a friend. What factors would you consider when deciding whether your money will be protected with your friend? Don’t you want to know what they will use the money for? Does that seem like a reasonable use? How responsible have they been in the past when they have borrowed money? What collateral will they give you? Do they have any skin in the game? How will they repay you? When will they repay you?
When you shift your perspective, and look at potential investment properties like a lender, you gain the ability to thoughtfully consider a potential property with a careful and objective eye.
Lenders want to know details about your past, current, and future financial situation precisely so they can accurately estimate risk. These details include your credit score, your experience in real estate investing, how much money you have, how much money you’re putting into the investment, how you have repaid previous loans, who is involved in the investment, and possibly several additional details.
2. Evaluate the Location and the Market Like a Lender
As Forbes reports, there are resources readily available to help potential investors find the right market that balances risk and reward; Local Market Monitor is one such website. But we want to convince you there’s more to location than location itself.
Just like with single-family investments, the key for multifamily real estate investing is to strike a balance between an established area with a strong economy and solid job prospects and an area with growth and desirability projected for the future. To start narrowing down the right multifamily property, think like a lender. A multifamily property’s address tells the lender a lot about the property and whether or not is a good investment.
Seek a location with high occupancy rates and a vibrant economy. Although it may be tempting to search for multifamily properties in more rural areas because of low price points and higher cap rates, rental markets in those locations are carry more risk and are not as attractive to potential lenders. Remember, you can’t make a rural deal with urban terms.
Media outlets like Business Insider evaluate multifamily investment markets using rates of employment growth, population growth, increase in home values, and rental yield. Do your own homework when researching a market’s average occupancy rates for rental properties.
Also consider the job market, the greater economy, industry, transportation, and how the local or state governments interact with all of those elements. Property markets must be attractive and sustainable to make a deal attractive for lenders. There are loans for all types of properties in all types of markets. Just remember that as economic factors such as population base and employment opportunities diminish, loan terms tend to get worse.
3. Calculate Budget Expenses Like a Lender
Lenders also have to take into consideration the possibility that a borrower may default on their loan. That means they will have to take back the property, so the lender will evaluate what it will cost them to operate the property in a worst-case scenario. Those considerations will be factored in their underwriting.
Typical lender underwriting allows for a 2 percent annual increase in income and a 3 percent increase in expenses. Lenders are also going to include a line item of $250 per unit per year to reserve for potential repairs. Another often-overlooked item is the payroll expense from the property manager. A property manager takes a management fee but also has to pay their staff to make site visits for repair work and leasing activity. A lot of first-time investors don’t include this in their underwriting.
There are many other additional factors you may need to take into consideration. Our general rule of thumb is to be incredibly thorough. Take into consideration all possible expenses when putting together your budget and pro forma so you have a realistic view of how the property will likely operate and how a lender will likely underwrite the deal.
Invest Better by Thinking Like a Lender
Let’s sum up. When making your next multifamily investment, think like a lender by evaluating three categories: risk, market factors, and projected expenses. Taking careful stock of the potential for risk and the stability of a market and forming a conservative estimate of potential expenses not only helps you accurately estimate loan options but also safeguards you from many investing pitfalls. If in doubt, remember: think like a lender.