What is real estate underwriting?

When an individual or business entity seeks funding for a real estate project or purchase, the loan request is scrutinized by an underwriter to determine how much risk the lender is willing to accept. These types of underwriters are not to be confused with securities underwriters, who work to determine the offer price of financial instruments. Real estate underwriters take into consideration both the land and the borrower.

The United States Department of Housing and Urban Development (HUD) defines underwriting as "the process of analyzing a loan application to determine the amount of risk involved in making the loan; it includes a review of the potential borrower's credit history and a judgment of the property value."

In most real estate loans, the property itself is used as collateral against the borrowed funds. Underwriters generally use a debt-service coverage ratio (DSCR) to determine if the property is able to redeem its own value. If so, the loan is a more secure proposition, and the loan request has a greater chance of being accepted.

The underwriter conducts research to ensure that the individual borrowing funds for the real estate purchase has represented him or herself truthfully, to get a sense of the applicant's finances, and to determine that the sale price of the property is congruent with its appraised value.

The underwriter is responsible for determining the potential borrower's creditworthiness. This rating represents the applicant's ability to pay back the funds lent, and it is determined by the credit scores provided by the three major credit bureaus, the amount of funds the he or she has in reserve, and his or her employment history.

When applying to borrow funds for a real estate purchase, a borrower is required to have an appraisal conducted on the property. The underwriter uses the appraised value to determine if the funds garnered from the sale of the property would be enough to cover the amount lent. For example, if a borrower seeks to purchase a home for $300,000 that an appraisal deems to be worth $200,000, the underwriter is unlikely to approve the loan – or at least, a loan for the full $300,000.

The origination of the term "underwriting" is typically credited to Lloyd's of London, an English insurance broker dating back to the 17th century, which gathered individuals to issue coverage for risky ventures, such as sea voyages. In the Lloyd's process, each risk-taker would literally write his name under text describing the venture and total amount of risk he was willing to accept in exchange for a specified premium.This later came to be known as "underwriting the risk."