How To Analyze A Real Estate Opportunity Like An Underwriting Pro

I’ve been investing in real estate for over four decades, and while I’ve learned a lot over that time, some of the most impactful lessons came not from my achievements but from my failures. 

Those particular lessons were hammered into my psyche in a way that I was unlikely to forget anytime soon. Unfortunately, those lessons, while powerful, are also often quite costly. That’s why I believe that despite the disproportionate power of learning from failure, it’s still almost always best to avoid failing in the first place. After all, you’ll get a lot farther if you don’t keep getting blindsided by costly mistakes. 

So, in today's article, I will break down the underwriting process we use in my real estate education community. You can follow this to increase your likelihood of turning a real estate opportunity into a profitable deal that improves your financial freedom. 

Who Are We Investing With Or Buying Assets From?

I was recently speaking at a real estate conference, and once I got off stage, I was deluged by some of the younger attendees who wanted to know what kind of deals I was looking at now that our economy had changed so drastically. 

I liked that they were paying enough attention to see through the “everything is fine” mantra currently being preached in the media. Equally important, I appreciated that they were proactive. Far too many people in this industry are complacent and, as a result, get trapped in a rut, especially newer real estate professionals who haven’t yet experienced a significant down cycle in the real estate market.

But there was also a flaw in their thinking. 

You must adjust your strategy to adapt to current market conditions, which come later. The first thing you need to do is know exactly who you’re getting into business with. 

It’s true that you’re investing in tangible assets such as land and buildings when you invest in real estate, but ultimately, you’re investing in people. Throughout a transaction, you’re dealing with sellers, buyers, and numerous others involved in the transaction, who all have their own motivations, knowledge, and level of integrity. This makes each deal infinitely more complicated than the numbers on a spreadsheet might first indicate. 

So, I always tell my community members and mentees that the most important skill they can learn is reading people, but taking it a step further is essential. Instead of just relying on your intuition, you should also scan their social media, search for complaints online, check references, and do a background check. And remember, you’re not just looking for things like lawsuits or criminal records. You’re also trying to gauge their expertise and character, good or bad.

Now, not every deal requires the same level of due diligence. Still, every deal requires some, and this is a step you should never skip because even experienced operators get tangled up with unqualified or unethical people when they do. That includes me. Yes, I’ve ended up in deals I wouldn’t have touched had I known more about the other people involved, and it cost me a lot. That’s why I’m so adamant about the topic. 

What Asset Class Are We Looking At?

Once we’ve done our due diligence on the people involved in a real estate opportunity, it’s time to dig into the asset class.

Three distinct asset classes are direct investment, syndication, and funds.

In a direct investment, you’ll have one investor and one asset. This is as simple as it gets, and it’s where most investors start. 

The capital requirements here are lower, it’s often easier to get funding, and many people already understand the basics of residential real estate. There are downsides, too, including a lot more direct, often hands-on involvement. You’ll need to either do any necessary renovations yourself or manage a contractor, which can be a full-time job in and of itself. You’ll also eventually need to find a tenant or buyer, depending on your plans for the property.

Next, you have syndication, which builds on that by bringing multiple people to invest in one asset. This asset class is used for more significant investments like multifamily, commercial, and senior living facilities.

This is typically a more passive investment because the syndicator, also known as a General Partner, will handle the property's renovations, management, and sale, so you don’t have to worry about any of that. (As long as they do their job correctly.) The syndicators will charge a fee to compensate for the work they do on your behalf. Depending on how they structure the partnership agreement, they may keep a portion of, or all of the depreciation, so if you’re looking at an opportunity specifically for tax purposes, you need to ensure you’ll get what you’re looking for.

And finally, funds offer the opportunity for multiple people to invest in a portfolio of assets. Think of this like a mutual fund, but instead of stocks, which are shares of fractional ownership in a company, you’re investing in fractional ownership of land and buildings.

People looking for truly hands-off investing often choose this route because they don’t have to do much other than cut a check. That simplicity comes at a price, though, with much higher fees and a lack of control and specificity of the assets included in the fund..

There are also different types of real estate, and some perform better than others under different economic conditions. Therefore, it’s critical to evaluate each opportunity first in the context of today’s market conditions and then in the context of the asset itself.

For example, speculative real estate opportunities tend to perform poorly because people typically hunker down in defense mode during an economic downturn. Not surprising, right? After all, it doesn’t make much sense to go after risky asset classes when facing an already risky economic environment. That just multiplies your risk exponentially.

So, what types of real estate perform best in today’s market? 

When we underwrite an opportunity in my company, I like commercial, but some sub-niches do better, and others do worse. Small office space can be risky today, thanks to the work-from-home model. I don’t know if that’s a good or a bad thing, but it is a factor we need to be aware of. Some of the larger companies are starting to tell their employees, “Hey, you need to start coming into the office again,” but I don’t know how big that impact will be. On the other hand, medical facilities tend to do better because no matter how bad the economy gets, people still need to see their doctors and dentists, and working from home isn’t an option here. 

Try to think of the products and services you’ve purchased at some of the lowest financial points in your life, and that will guide you to some of the asset classes you should be looking at right now. This might include automotive, veterinary, and childcare facilities, but it could also be more general real estate with certain tenants. So that could be any kind of commercial property, from small independent buildings to giant strip malls, but instead of seeking just any tenant, you’ll seek tenants that tend to weather recessions better. Some examples include credit repair agencies, discount stores, accounting firms, property management companies, and pet grooming facilities.

These are just a few examples, but I think you get the idea—you need to carefully evaluate opportunities in the context of the economy and the opportunity itself.

You also need to evaluate opportunities from the perspective of your own knowledge and experience. This is why so many people get started in residential real estate—they understand houses better than other types of real estate because most either live in one now or have in the past. That also often leads to a false sense of security due to the Dunning–Kruger effect, where people with some inherent knowledge overestimate how much they actually know. It’s also one of the reasons I always recommend finding a mentor.

Keep this in mind when making decisions. It’s easy to convince yourself that an opportunity will yield a windfall profit, especially if you’re not very experienced yet. So, you need to really crunch the numbers and ideally bring in a more experienced set of eyes for a second opinion. 

Why Is This Opportunity Right For You?

There’s a story behind every opportunity, and that story can give you valuable insight into whether it’s right or wrong for you.

The first thing you need to know is why the current owner is selling in the first place. Maybe he’s liquidating because getting ready to retire, has fallen on hard times, or to create the capital to purchase another property. Those are all reasons that shouldn’t necessarily worry you. On the other hand, maybe he’s selling because he knows of an upcoming development that will cause the property value to drop. A reason like that absolutely should worry you.

This reason will give you a lot of insight into whether an opportunity is right or wrong for you.

You also need to evaluate the asset itself. Do you understand real estate well enough to know how to operate this particular asset class? Or do you understand the business model of your potential tenants well enough to know the pros and cons of their industry? For example, an inexperienced operator might be excited by a flood of potential tenants, but what if those tenants want to put a vape shop on the property? Maybe that seems like no big deal. Who cares what people do in their free time with a legal product, right? An inexperienced operator probably doesn’t realize that vape shops tend to attract crime, which is why many owners won’t rent to them in the first place.

Economic factors play a role, too. You need to carefully evaluate your financial situation and the broader economy to determine if an opportunity is right for you. This is critical because while an opportunity could be terrible for you, it could still be an excellent opportunity for someone else because their situation differs from yours.

Here’s how that could play out—let’s say you wanted to purchase two separate properties, demolish the buildings, rezone the lots into one, and construct a new building on the now larger lot. This is the kind of opportunity that can produce a substantial return on investment, but it’s probably not a fit for most investors because the cost will be significant and it will take years to complete. Most investors aren’t adequately capitalized for something like this, so while it’s a great opportunity in general, it’s unfortunately a terrible opportunity for them. The difference here is subtle but important.

Following A Documented Process Is Key...

Mitigating risk as an investor is the name of the game. While there is no bulletproof plan to ensure every real estate opportunity is a win, following a documented underwriting process is the closest thing to it. A lot can go wrong, but if you know where to look during underwriting, you can identify and avoid most problems.

This article is from an unpaid external contributor. It does not represent Benzinga's reporting and has not been edited for content or accuracy.