The 7 Steps Of Underwriting

Every seller-financed acquisition needs the same underwriting flow. Different operators have different spreadsheet styles, but the questions to answer are the same.

Step 1: Verify Income

Pull the rent roll. Verify against:

  • Lease copies for every unit
  • Bank statements showing deposits matching rent roll
  • Rent comparables for the submarket

Calculate effective gross income: gross scheduled rent minus vacancy minus credit loss plus other income.

Underwrite vacancy at 5 to 8 percent regardless of seller's claimed numbers. If the property currently runs at 2 percent, that is a current snapshot, not a stabilized assumption.

Step 2: Verify Operating Expenses

Pull a trailing 12-month operating statement. Verify against:

  • Property tax bills (multiply by current millage)
  • Insurance declarations (or get a quote in your name)
  • Management fees (typical 7 to 10 percent of collected)
  • Utility bills if landlord-paid
  • Repairs and maintenance (typical $300 to $600 per unit per year for older properties)

If the seller reports operating expenses below 30 percent of gross income, they are either understating costs or running an unsustainable operation. Real properties run 35 to 55 percent operating expense ratio. Use that band.

Step 3: Calculate Current NOI

NOI equals EGI minus operating expenses. This is the baseline.

If the seller's claimed NOI is materially higher than your reconstructed NOI, document the difference. Sellers often add back personal expenses, ignore vacancy, or omit reserves. Use your reconstructed number, not theirs.

Step 4: Model The Forced Appreciation Plan

What can you do to grow NOI over 12 to 24 months? Common levers:

  • Rent to market: 5 to 15 percent of current rents
  • Vacancy reduction: 2 to 5 percent
  • RUBS implementation: $50 to $150 per unit per month
  • Expense optimization: 5 to 10 percent of OpEx through better insurance, better vendors, energy efficiency

Be conservative. Use 70 to 80 percent of upside as your underwriting assumption.

Example: 12-unit at $900 rent with market at $1,050. Current NOI $44,000. If you push half to market by month 12, that adds $900 per month, $10,800 per year. If you also drop vacancy from 12 percent to 7 percent, that adds another $6,500 per year. Stabilized NOI projection: $44,000 plus $10,800 plus $6,500 equals $61,300.

Step 5: Calculate The Acquisition Cap Rate

Acquisition cap rate equals current NOI divided by acquisition price.

If you are paying $600,000 with current NOI of $44,000, your acquisition cap rate is 7.3 percent.

Compare to:

  • Submarket median cap rate
  • What a stabilized property in the area sells for

If your acquisition cap is significantly tighter than the submarket median, you are paying a premium that is hard to justify. If it is wider, you have margin built in.

Step 6: Model The Refi Exit

Refi value equals stabilized NOI divided by exit cap rate.

Use the historical median cap rate for your submarket, not the recent low.

Stabilized NOI of $61,300 at an 8 percent exit cap rate equals $766,250 refi appraised value.

At 75 percent LTV cash-out refi: $574,688 loan amount.

Subtract seller note payoff at month 18 (call it $530,000 if you put $30K down and amortized lightly): $574,688 minus $530,000 equals $44,688 of cash pulled out at refi.

Add back your initial $30,000 down: full capital recycled equals $74,688.

Step 7: Stress Test The Plan

Run two scenarios:

Downside: What if rents only grow half what you projected? What if vacancy stays at 12 percent? What if exit cap rate is 9 instead of 8?

If the deal still produces positive cash flow during the hold and the refi at least returns your initial capital under stress, the deal is robust.

Upside: What if rents grow faster than expected? What if cap rates compress to the submarket low? What is your IRR?

If upside is muted but downside is severe, walk away.

The Worked Example - Full Underwriting

Property: 12-unit garden style. 8 of 12 units at below market rent.

Acquisition:

  • Price: $600,000
  • Seller financing: $570,000 at 5.5 percent, 25-year amort, 7-year balloon
  • Down: $30,000
  • Closing costs (title, attorney, due diligence): $8,000
  • Total cash in: $38,000

Year 0 NOI: $44,000 (acquisition cap rate 7.3 percent)

Year 1 plan:

  • Roll 6 of 8 below-market units to market: adds $9,000 NOI
  • Drop vacancy from 12 percent to 8 percent: adds $5,000 NOI
  • Reduce R&M with new vendor: saves $2,000
  • Add laundry income: $1,800

Year 1 NOI projection: $61,800

Debt service (seller note): $42,000/year

Year 1 cash flow: $61,800 minus $42,000 minus $3,600 capex reserves equals $16,200

Cash-on-cash return year 1: $16,200 / $38,000 equals 42.6 percent.

Refi at month 18:

  • Trailing 12 NOI by then: $63,500 (slight further growth)
  • Submarket exit cap: 8 percent
  • Refi appraised value: $793,750
  • 75 percent LTV refi: $595,313
  • Seller note balance at month 18: $548,000
  • Cash out at refi: $47,313

IRR over 7-year hold to balloon:

  • Year 0 cash out: ($38,000)
  • Year 1 cash flow: $16,200
  • Year 2 cash flow: $17,500
  • Refi at month 18 returns $47,313 minus refi costs $8,000 equals $39,313
  • Years 2 through 7 cash flow (post-refi at lower debt service): $24,000 to $28,000 annually
  • Year 7 sale at 8 cap on $72,000 stabilized NOI: $900,000
  • Less loan payoff: ($560,000) leaves $340,000 equity
  • IRR: approximately 28 to 32 percent

Stress Test

If exit cap moves to 9 instead of 8: refi value drops to $705,000, refi loan drops to $529,000, cash out at refi drops to negative $19,000. The refi pays off the seller note but leaves no cash. You still hold a cash-flowing asset but you do not recycle capital.

If rents only grow half projection: stabilized NOI of $52,000 at 8 cap equals $650,000. Refi loan at 75 percent of $487,500. Below seller note balance. Refi does not work.

That second scenario tells you the deal is leveraged on rent growth happening. If you cannot make rents grow, the deal is fragile. Plan B: bridge loan or balloon extension.

What Good Underwriting Looks Like

  • Three scenarios (base, downside, upside) with stated assumptions
  • IRR calculated to year 7 or balloon date
  • Exit cap rate clearly stated and defended
  • Forced appreciation plan tied to specific actions (not vague)
  • Stress test that shows the deal survives realistic adverse outcomes

If your underwriting cannot survive a 100 basis point exit cap expansion, the deal is too tight. Walk away or restructure the offer.