This is part 4 in the Underwriting Series. If you haven’t done so, go back to post one, two, and three before reading this one.
This whole series started off being one post and has continually grown (just like your apartment portfolio!) more than I expected. We are now into the underwriting area and I’m finding that it will take more than a single post to give this the service it deserves. So, rather than titling this Multifamily Part 4, Underwriting Part 1, I’ll just stick to the single numbering scheme. Sorry for the confusion. I’m a lot better investor than I am a writer.
How to Underwrite
This is what you came here for. Let’s get started.
Recall that you have already gone through the initial and secondary evaluations and this deal is one you believe is a keeper. You aren’t sure yet, but it hasn’t had any red flags triggering you to dump the deal. Right now you want factual information, and the seller is not going to give it to you unless you show you are serious. This usually takes the form of a purchase and sale agreement (PSA).
You may be wondering if I skipped an important step, the Letter of Intent. I sure did, but this post is about underwriting, so read that post if you want to get up to speed. The rest of this post is going to assume you are under contract. At some future date we will talk about what goes into a PSA.
Underwriting takes the following steps: Have a solid PSA, which requires the seller to give you information, gathering information, analyzing income, analyzing expenses, calculating metrics, stress testing, and talking to the bank again.
PSA
I’ll briefly talk about this here, but you can expect a bigger post on it in the future. The PSA will have some statement that requires the seller to present to the buyer, within a certain number of days, a bunch of information. It also has a termination clause which the buyer may exercise if the seller does not produce the documents. Additionally, it will have terminology that if the buyer is not satisfied with the information, the buyer can back out. The information requested will have some specifics to the property but generally will have: T12 (trailing 12 months profit and loss statement), profit and loss statements for 3 prior years, tax returns for the property’s owner for the prior 3 years, a list of any capital expenditures in the past 3 years, a list of any insurance payouts in the past 5 years, the current rent roll, a phase 1 environmental site assessment (if it exists), and the property’s bank statements for past 3 years. The time frames on these may change. This is not a comprehensive guide to the PSA. Consult an agent or attorney before offering.
Gathering Information
Here are the steps you should take to get all the information. Do this before analyzing it.
- Check the GIS (graphical information system) in the area. It’s usually run by the county and usually free. You can see if there are any issues with the property boundaries and verify the owner of the property. Take note that the GIS’s property lines are for information only and not legal. They may vary with the actual survey.
- Check the zoning. This might be done in the GIS or may be some other system in the area. Make sure the zoning is appropriate to the property which sits on it. Different jurisdictions have different terms for this. It might be zoned multifamily or high density residential. Read the definitions and consult an attorney if you are not sure.
- Check the tax records. These are usually public information and can be searched for online. Write down how much tax the property paid in the previous cycle. Determine what the property mil levy is for the area (this is the property tax rate). This levy might be on the website or you may have to call the county auditor.
- Check the flood map. You can go to fema.gov to type in the address and review the flood map. If the property is in a flood hazard area, you may have a hefty insurance bill.
- Gather market research. You should already have some of this information that you compiled when you were deciding on this market (also beyond the scope of this series). This info includes local demographics such as population growth, employers in the area, universities, and hospitals. You probably won’t have rent information, so this step will have you searching for apartments as if you were a renter. Find out what they are asking as that is a good way to determine what they are going for. This can be done online or by driving around and calling for rent numbers. Also find out if they are giving concessions (free things like a month’s rent to entice renters to sign). These properties should be similar in size, shape, amenities, and location to your subject property. The closer the better. Put it in a spreadsheet and use it to calculate a price per square foot. That’s your market rent.
- Document the physical characteristics of the property. You may or may not have done a walk-through yet. In bigger properties, the buyer is not on site until after the PSA is signed. This saves the buyer and seller the hassle of going there only to not get an agreement signed. The characteristics looking for are going to be any major deferred maintenance, which will incur a big expense, or any amenities that the buyer wants to install and will come at a cost. This is NOT the physical inspection.
- The physical inspection. Pay an expert to do this for you. Take it from someone who has had to foot the bill for major electrical and sewer work. Get an inspector. The inspection definitely part of the due diligence, but only peripherally part of the underwriting. If there is some major finding, it’s cost will go into the underwriting.
Keep in mind that these things are happening concurrently. After you go under contract, there is a flurry of activity to get things done on time. Make a plan and stick to it. Next time we will talk about analysis of the income.
