Financing real estate investments is a key step toward achieving the maximum return on investment (ROI) on any project. Borrowing allows the investor to control a larger asset with a smaller amount of capital. Increases in the value of the total asset are larger when expressed as a percentage of the capital actually invested. Leverage is such a critical element in successful real estate investing. A sensible business strategy is to evaluate any potential real estate property from the underwriting standpoint of a lender.
This is not putting the cart before the horse. Underwriting is simply one of the filters that experienced real estate investors use to evaluate projects before signing on. In this sense it is no different from considering the market for a fix and flip residence. Nor is it different from considering the increase in rents that can be achieved by upgrading appliances in an apartment. Furthermore, looking at any property from the underwriting point-of-view of a lender is straightforward and easy to include in a systematic approach to real estate investing.
Concerns of a Real Estate Lender When Underwriting a Loan
One of the most basic underwriting concerns a lender has is the ability and willingness of the borrower to make the payments on time. The second concern is addressed by the history of the borrower. This is why a good credit score is an important asset for a real estate investor. A strong track record with similar types of real estate investments also demonstrates the ability to properly manage a project, including handling the monthly interest payments.
The first point, the ability to properly service the debt, is a function of cash flow. Real estate investors are somewhat notorious for being optimistic on this point. They differ from lenders on this approach. Lenders want to be comfortable if something goes wrong. Basing the ability to pay on a 100% occupancy rate while remodeling the building might not pass the lender’s test. Showing the ability to pay based on income from other properties or employment is a much stronger case.
Real Estate Lenders Set Realistic Standards For a Loan
Lenders, like the rest of humanity, want to sleep well at night, and the best sleep comes from knowing that a loan has adequate collateral. After all, collateral is the last resort the lender has against taking a loss on a loan. Adequate collateral can be defined in a practical sense as a loan-to-value ratio of 70%. In other words, a lender is unlikely to lend more than $70 for every $100 of real estate value. This ratio gives them some cushion against optimistic appraisals or a poor buying decision on the part of the borrower.
Real estate investors are always looking for under priced properties, and so may see a greater value than what the market is currently supporting. Lenders are not so optimistic or forward looking. They tend to believe that the market price is the actual value of a property. This means that evaluating the ability to make a sizable down payment needs to be part of the investors’ calculation when considering a real estate investment.
There are other considerations that come into play when financing real estate, but the ability to pay, the willingness to pay and the value of the collateral are three main considerations. Certainly, a loan application with these three elements in place will pass an initial underwriting review. Loans that do not meet at least these basic criteria face potentially insurmountable difficulties.
Developing the ability to evaluate a real estate project from the perspective of a loan underwriter can be a valuable skill for the investor. Optimism is a powerful motivator, and sometimes taking a more cautious point-of-view brings a valuable pause to a transaction. “Fools rush in where angels fear to tread”, as the saying goes, might be recast in with lenders playing the role of the wise and cautious.