A typical real estate transaction has so many moving parts, it can be easy to get lost in the details. Amid market fluctuations, advances in technology and changes to the homebuying industry, today’s investors are required to pay extra attention to make sure nothing falls through the cracks.
One part of the transaction process—real estate underwriting— exists specifically to help investors (and lenders) avoid potentially risky deals. Read through the following guide before you approach your next deal and learn how to make the best use of underwriting real estate.
Real estate underwriting is the process of reviewing a loan application to determine the amount of risk involved. The underwriter will look at the borrower’s financial standing and the value of the property at hand to review the potential of the deal. Underwriting is a crucial part of the transaction process as it can help both investors and lenders bypass unsuccessful properties.
Simply put, real estate underwriting can be thought of similarly to the pre approval process for a loan. Both analyze a borrower’s finances to determine the viability of a deal. The difference is that underwriting specifically considers the level of risk involved, and in many cases, requires extra information from the borrower to do so. This comprehensive process is not always required by lenders, so many investors will actually learn how to underwrite a deal themselves (with the guidance of a financial advisor).
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Definition of Underwriting
The underwriting definition is the process of accepting liability when an investment is made and guaranteeing payment in the event of loss or damage. Underwriting is not exclusive to real estate and can be used for any type of loan, investment, or insurance. According to Investopedia, underwriting originated from a practice where investors would leave a signature under the amount of risk they were willing to take on in a given deal. While the process is much more formal now, the name underwriting is still associated with this type of risk evaluation.
What Does an Underwriter Do?
An underwriter’s role is to research the borrower and investment to determine the security of a loan. One of the main factors they will look at is the debt service coverage ratio (DSCR). This metric is calculated by reviewing the net operating income of an investment in relation to the total loan amount. Essentially, this will reveal if the profits made from the investment will be enough to repay the loan. The underwriter will use this information, along with a few other factors, to determine whether or not a loan should be approved.
Further, underwriters are responsible for making sure there is enough collateral securing the potential loan. Most real estate loans will use the property as collateral, meaning the property could be seized by the lender in the event of default. For the real estate underwriter, this involves confirming that the property value does not exceed the loan amount. The underwriter will use the appraisal amount to evaluate the size of the loan. The underwriter will likely not approve financing if for some reason the loan exceeds the appraisal value of the property,
How Does the Real Estate Underwriting Process Work?
The real estate underwriting process can start one of two ways: when an application for a loan is submitted, or when an investor decides to complete the underwriting for a potential deal. Most commonly, underwriting will be initiated by a lender once a borrower submits a loan application. Many traditional lenders will actually require underwriting before issuing a mortgage loan. Underwriters will need identifying documents and credit reports from a borrower to complete a thorough evaluation. The underwriter will then request a property appraisal.
A typical underwriting process can take anywhere from a few days to a week to complete. The longest portion will be making sure the necessary paperwork is promptly submitted. Any borrowers hoping to speed this up, should prepare the required documentation in advance and should be responsive to any communications from their lender. The final step in the process is the decision and the review of any approval conditions.
The real estate underwriting process can also be completed by real estate investors looking to evaluate deals themselves. This involves reviewing the property numbers through a careful deal analyzer. Factors to look at include net operating income, return on investment, and more. Investors who opt to underwrite their own deal will then have it reviewed by a third party (typically a broker or financial advisor). Next, investors will anticipate possible scenarios and plan potential reactions and outcomes. To be clear, underwriting real estate yourself is not a way to get approved for a loan. Instead, it is another tool that can be used to evaluate risk in a potential deal.
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As investors seek to adapt to the changing real estate industry, it can be easy to overlook the smaller features in any given deal. However, dedication and a strong attention to detail are what distinguishes savvy entrepreneurs from their peers. Before you approach your next property, whether it be residential or commercial, familiarize yourself with real estate underwriting. This process can help you avoid potentially risky investments and find successful additions to your portfolio, sooner.
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