Underwriting is the system through which a person or business takes on financial risk for a fee. Typically, this risk involves investments, loans, insurance, or real estate. It is called underwriting because risk-takers literally write their name under the amount of risk they are willing to take on for the agreed-upon fee.
Over time, the process has evolved and the process is much different, but underwriting remains a major function in investing.
Real estate investors need to understand the process of underwriting that all lenders use. Does real estate underwriting influence the entire process of getting a mortgage? How long does it take? What exactly is real estate underwriting?
How does underwriting work?
Underwriters research and assess the extent of risk each applicant or entity brings in before taking on that risk.
Exercising due diligence allows for fair lending rates for loans, provides the right premiums to sufficiently cover the real cost of insuring policyholders, and establishes new markets for securities by pricing investment risks accurately.
Risk is the number one factor in all underwriting. If an underwriter sees that the risk is too high, he or she may refuse coverage.
For loans, the underwriter evaluates whether the borrower will be able to pay back or not the mortgage as agreed on. With insurance, the risk involves the possibility that policyholders will file claims too soon. As for securities, the underwriter assesses the profitability of the investment.
Underwriters assess loans, especially mortgages, to find out if the borrower will pay at the specified time with the specified amount and that the applicant has adequate collateral in case of default.
Features of underwriting real estate
Underwriting in real estate is similar to that of other industries. But, it does have some other features not present in other sectors. Real estate underwriters do need to have a good understanding of the market, and they need to cover a wider scope of analysis.
Also, they not only need to assess the applicant’s ability to pay, but they also have to evaluate the property itself. Below are the basic elements of the real estate investment underwriting process.
- Cash flow projections
The initial step for underwriters is to estimate the cash flow that the income property will generate. This step is crucial because it provides the lender with information on the investment’s capacity to service the debt.
The lender will look at different metrics like the gross income and net operating income. If they see that the property will provide positive cash flow, then it is highly likely that they will approve the loan.
- Estimation of potential ROI
The next thing they do is to forecast the possible return on investment of the property. To do this, just divide the net operating income by the appraised value or sale price of the property. This will allow the lender to ascertain the cap rate of the investment property.
- Reviewing the borrower’s credit history
This step is just as vital as any step in this process. Here are the things lenders look at when reviewing a borrower’s credit history.
- Payment history
- Credit use history
- Amount of outstanding debt
- Track record of responsible use of credit
- Debt-to-income ratio
If the lender is satisfied with the applicant’s credit history, they may assign the applicant a credit rating. Borrowers with a poor credit history will be rejected.
- Reviewing the asset involved.
Here are some of the most important questions about the property that underwriters need to find answers to.
- Is the property in a good location?
- Is the purchase price below market value?
- Is the property in good condition?
- If the property needs rehabilitation, how much will it cost?
- How long will the project take to finish?
- What is the exit strategy?
How to maximize your chances of loan approval
If you wish to apply for a loan, you have to make sure your application is organized. Here are some tips to increase your chances of getting a loan approved by underwriting.
- Get ready to share all financial details with the lender.
The worst thing you can do is to hide your financial details from the lender. Lenders would naturally want to know your financial situation, so it is important to share your documents that show your income. Among these documents are income tax returns, certificates of employment, and pay stubs.
- Hire a professional to appraise your collateral
How much your collateral is worth is one of the major factors that influence the lender’s decision to approve the loan or not. It is therefore important to have a general understanding of mortgage lending and property appraisal.
Always keep in mind that the underwriter works to protect his or her employers, so they will always set the terms that are favorable to them and not you. They typically issue a loan based on the loan to value ratio. Thus, appraising your property is a must before you apply for a loan.
- Submit all required documents
It seems common sense, but some borrowers forget to submit all required documents. Some loan applications get rejected due to incomplete documents. Take time to organize everything before applying for a loan.
- Make a good first impression
Lenders tend to trust individuals who have strong personalities. Also, borrowers who have a clear business plan and can communicate it confidently will gain the lender’s trust.
Other types of underwriting
- Insurance underwriting
Here, the focus is on the possible policyholder. Insurance underwriting evaluates the risk of insuring possible policyholders based on their health, lifestyle, age, family medical history, occupation, hobbies, and other factors determined by the underwriter. It can result in either an approval o rejection and set rates.
- Securities underwriting
Securities underwriting evaluates risks and the correct pricing of specific securities. It is usually related to an initial public offering. In this case, underwriters perform due diligence on behalf of a potential investor. The potential investor would buy the securities based on the results of this process.
Underwriting is an often-overlooked process because underwriters work behind the scenes. The process varies by sector but ultimately is about accessing risk. This process diminishes the risks of expensive defaults and allows lenders to give competitive rates to those borrowers who are less risky. In the investment realm, many platforms and brokerages do additional underwriting, digging into the details of an offer to give their clients more information and peace of mind in their investment choices.