Underwriting

There are nuances between the different asset classes but in general underwriting looks at the cash flows that an asset or building if you will pays out to the owner/lender/fund/shareholder.

OPERATING CASH FLOW For real estate purposes you do not use the terms EBITDA, EBIT or P/E Multiple. While you can and some funds do look at these for the most parts since you are dealing with an individual asset. A real estate underwriter would look at the total amount of revenue that a building takes in, or gross rents. Next you look at the vacancy factor, or how much of a buildings square feet, or apartments are unused. You then subtract the vacancy amount from the gross revenue to get to the effective income. Which is exactly what it sounds like, the actual rent and revenue that the building brings in, not just the potential gross income which would be if the building is 100% occupied, which is never(exception is retail but a static vacancy factor is used).

EXPENSES Next you get to expenses, fixed and variable expenses which are paid from the cash flow to operate the building. Since real estate is the most labor intensive asset class of structured finance expect these to be a lot in the 30%-40% of the gross revenue. Depending on the building and product type(e.g. Multi-family"apartment buildings", Office, Retail, and Hospitality"hotels") these will be different. But, again, generally you will always have to pay real estate taxes on the building you own or plan to own, heat/gas/oil, water and sewer, payroll, lawyer fees, janitorial/custodial services, property/Asset Management services, electricity. Now there can be many more and you can break down these expenses into sub categories(e.g. hallway lighting, elevator lighting, bathroom lighting), they would all go under electricity. Now before I get into the metrics or how to value and use the income and expense information you would gather, I will state that most expenses are looked at as a dollar amount per square foot, that is how you are able to compare two similar buildings. Now if you take the effective revenue and subtract the total expenses that will give you the Net Operating Income or N.O.I.. This is the most important number in real estate that people will talk about, NOI.

METRICS Now how do you make sense of all those numbers you came up with, Potential Gross Income(PGI), Effective Gross Income(EGI), Net Operating Income(NOI)? The next step is to see how those returns are if you or, if you are a lender your borrower stack up. Basically should I buy or should I lend on this property. This is the most important part of underwriting, the first part above was gathering the data now you must understand what it means. You probably remember the great recession of '07 and '08..and '09,'10,'11 etc... what you might remember from this or watching the Big Short is that people buy real estate with loans(debt). Very few people buy commercial real estate without any type of loan so most owners/potential buyers and banks want to know how much is the biggest amount of debt they could take out/loan. From here on I will write this like you were an analyst for an owner group. Most banks will have a minimum amount of cash flow that you must have to take out a loan. The most simplistic of underwriting will look at the 1st year a property is run, the most complicated will look at 5,7,or 10 years out and have a discounted cash flow. Let's just look at the simplistic "model". So for that first year banks will want to know what a specific property's cash flow can accommodate. I will assume you know how to get a present value in finance for the next part. So banks will take a look at the D.S.C.R.(Debt Service Coverage Ratio). This is given as an example of 1.20x cash flow(NOI), so you look at the monthly payment of the biggest mortgage you can accommodate on the property. You take your NOI divide it by the DSCR, in this case 1.20x, and you get your monthly payment. Then search for the Present Value by inputting the Future Value: 0, PMT: Yearly NOI/DSCR, Interest Rate: use 4.50% for sizing purposes, Number of Periods: 30 years. Then search for PV and the number that gets spit out is the maximum loan amount that you can get based on the cash flows of that particular building. Now this is just an example, the interest rates are different depending on property types and who the buyer is and the the occupancy is of the building, but for your purposes it is a good rule of thumb. In practice you will most likely have to convert all those inputs into monthly numbers. The other metric that you will look at is LTV or Loan to Value, it is the % of your mortgage versus the market value of the property. Now when I mentioned that banks will have a minimum of 1.20 DSCR they will also have a maximum LTV that they will lend to and the loan amount if the lesser of DSCR and LTV.

Summary

This is very long winded and very simplistic for a nuanced practice. IF you have any questions feel free to reply as I know there must be some things to clarify.