When deciding to acquire a new piece of property, it is really important to understand the financials of the property; this is the process of underwriting.
Not all underwriting is performed by banks, and there are varying degrees of how in-depth you will go. Generally speaking, the larger the property (dollar value-wise), the more precise you will need to be in your underwriting analysis to avoid costly mistakes down the line.
One of the most common mistakes investors make when underwriting a new property acquisition is to rely too much on the seller-provided data and not enough on their data. Not everyone will operate the property in the same way, and this is not only true of expenses but also in income as well as plans for the property. While you need a baseline understanding of the asset you are considering, which you can get from the seller’s data, you need to keep some key points in mind.

The biggest and most overlooked, but has a huge impact on your operation cost for a property, is the property taxes. Sellers will provide you with what they pay in property taxes but never consider the reassessment to the new buyer. How real is this issue? Well, let’s say you are purchasing a property that is in a taxing district that has a property tax liability of 2% of the assessed value. The seller, who has had the property for about seven years or so, purchased it for $300,000 and paid roughly $6,000 a year. Over the last several years, he has raised the rents, compounded with increased market values, and now you have a property that is worth $1,000,000, which is where you are buying it. The taxes will reassess, usually the next tax cycle, but they will reassess what you paid for the property, and now, the $6,000 tax bill you factored in because you relied on the seller’s numbers is, in fact, $20,000 a year, a $14,000 per year increase or $1,166 per month of additional expense you did not anticipate. To put that in perspective, if you are using a cap rate evaluation (see blog on cap rates for the meaning and calculations) and the cap rate is a 7, this just had a negative impact of $200,000, which is a drastic value difference as well as cash flow difference on an asset of this size.

Another common mistake I see newer investors make is understanding vacancy rates. If the property is fully occupied at the time of a sale, then the seller will often give you their numbers as $0.00 in vacancy; however, over time, this is impossible to achieve even to the best of standards. For that to happen, you would have to move into the property the same day people move out every time. That means each unit will be in perfect condition each time and no work or clean up, even if there is just 1 day in between, which is still impossible, you would have a vacancy. Depending on the market you are in, the rate will fluctuate, but most banks will have a rate of 5% (give or take), and if you are a good, experienced operator in a decent market, that is very achievable.
In staying in line with vacancy, another common issue when evaluating a property with a vacancy is the bank’s actual underwriters. Often, investors, when purchasing or refinancing, will give the property’s income as to what they r, received, which is good, but that would include the vacancy they already have experienced. Most underwriters who work for banks don’t have a clue as to how properties operate. They get the numbers and assume the number you gave them was full occupancy, and they, in turn, apply a standard underwriting vacancy rate of, say, 5%, thus stressing the property additional vacancy that is not necessary since the income you supplied already included missed months of rent due to vacancy because you supplied the number collected over the last year. I have seen this happen time and time again, and it can be the difference in getting a loan for the acquisition or not, so when you do submit the property’s financials, make sure you are clear that the income number is actual income collected over the previous year which would account for any vacancy you experienced. If there was no vacancy over the previous 12 months, then the bank underwriting will have to apply their standard percentage for the same reasons you, as a buyer, need to when a seller tells you there is no vacancy.

Another overlooked expense when underwriting a new acquisition is property insurance. There are several variables when it comes to insurance, and the pricing can vary drastically from one insured investor to another, even on the same property. If you have a new mortgage and it’s considerably higher than the seller’s mortgage, then you will need more coverage, thus a higher premium. If you have replacement costs and they have actual cash value, that could be another variable. If you are newer to investing and they have several properties and a larger book of business, they may be getting discounts. It’s always best to contact your insurance carrier and get a quote for the insurance you need. If you are going to shop for multiple quotes, then get a declaration page with the quote itemized and send that to other carriers so that you can get apples-to-apples comparisons on your insurance quotes.
A lot of sellers that have owned the property for a while may self-manage the property, and if you are a newer investor who is still working a full-time job, you may be looking to be more passive and need to hire a property management company. This becomes a sticking point when you are trying to make financing work for a deal that may be relatively tight to begin with. I always make the argument that even if they are not paying for management, their time should be worth something and considered; however, that argument is pretty futile. If the deal is that thin and you need this expense to make it work, then it’s probably best to walk away; however, if you are looking at the total picture of the asset and the seller does not have those expenses in there, it is best to forecast them. To do this, you don’t have to guess, contact some property management companies and have them give you a quote for services. You will also want to make sure you get a quote for more than just their management fee but also their fees for maintenance expenses, leasing expenses as well as other administrative costs to get a real sense of the true cost of the management.

So far, we have talked about the expenses to consider when underwriting a new asset, now, let’s talk about the income you can recognize that the seller isn’t currently achieving. I know what you’re thinking: “How can I get more income than the current seller?” There are a lot of property owners out there who get stuck in a rut and just maintain the status quo and do not capitalize on new market trends, improvements, and rent growth, this is where you can look at an opportunity to see what value you can add with some renovations and repositioning of the property.
Capturing rent growth that the previous owner did not is one of the most sought-after types of opportunities in investment real estate. The trick here is to balance out the cost of the needed renovations (things like flooring, painting, fixtures, etc.) and know what the current market rental rates are. Additionally, there are other opportunities to look at capturing, such as fees for pets, late fees, and other opportunities to maximize income.
No matter what type of asset you are investing in, just remember that it is important to perform full due diligence on it. Take the seller’s expenses with a grain of salt, especially the variable ones, and recalculate the fixed expenses that you know you will incur, such as property taxes, insurance, management, etc. By doing this, you can be sure to put forward your best offer and know that you are making a well-thought-out investment choice instead of buying yourself a problem that you will either be fed with cash or be upside down on.