Good underwriting is the backbone of every successful real estate transaction. Experienced deal sponsors evaluate each transaction that comes across their desks, in search of deals with strong fundamentals and solid upside potential.
ArborCrowd views hundreds of deals each year from our proprietary network of relationships. This article explores the first step of ArborCrowd’s multistage underwriting process, which is called screening the deal.
Screening the Deal
Whether it’s a ground-up development or value-add transaction, sponsors need to weed out mediocre investment opportunities by screening deals.
This involves creating a financial model — often referred to as a pro forma — that spells out the business plan. The pro forma depicts how all sources of money in the capital stack will be spent, including for property acquisition, construction and other expenses. Furthermore, it lays out precisely how a project’s business plan is expected to generate income and how the sponsor intends to exit the investment and distribute profits to investors.
Through their financial model, sponsors will evaluate if the economics of the deal are feasible, the renovation or construction costs are reasonable, if it will be possible to fill the building with new tenants at higher rents, and whether the property is expected to sell at a gain. Ultimately, it lays out if a project is worth the risks the sponsor anticipates it will take.
Within a financial model, there are dozens of data inputs, also called assumptions, that sponsors need to apply.
Every market is different, and sometimes, even the distance of just one block can drastically impact those assumptions. Sponsors rely on various sources of market data, historical sales and performance, and most importantly, their experience to ensure their assumptions are realistic in the subject market.
An effective way to obtain proper assumptions is to understand a property’s competition by researching the performance of nearby comparable properties and by visiting the area.
Additionally, sponsors analyze the pipeline of newly constructed units coming to the market. Combined, these integral steps can reveal whether a sponsor’s post-renovation rents will be perceived as a bargain compared to other apartments in the area, and therefore the project could be appealing to tenants.
Proper underwriting increases the chances of a deal being successful, and without it, sponsors are taking undue risks with investors’ money. ArborCrowd’s transactions are not only underwritten by the deals’ sponsor. Rather, ArborCrowd performs an independent and comprehensive analysis of each transaction, passing on hundreds of deals a year to find only the ones that we believe exhibit strong fundamentals and upside potential.
Learn more about the underwriting process here.