Commercial Financing is
underwritten on a case by case basis. Every loan application is
unique and evaluated on its own merits, but there are a few common
criteria lenders look for in commercial loan packages.
Commercial Underwriting Guidelines
Commercial
Financing is underwritten on a case by case basis.
Every loan
application is unique and evaluated on its own merits, but there are
a few common criteria lenders look for in commercial loan packages.
Financial
Analysis
A key component in
making an underwriting evaluation is the debt coverage ratio. The
DCR is defined as the monthly debt compared to the net monthly
income of the investment property in question. Using a DCR of 1:1.10
a lender is saying that they are looking for a $1.10 in net income
for each $1.00 mortgage payment. Typically they will determine the
DCR ratio based on monthly figures, the monthly mortgage payment
compared to the monthly net income. The higher the DCR ratio the
more conservative the lender. Most lenders will never go below a 1:1
ratio ( a dollar of debt payment per dollar of income generated).
Anything less then a 1:1 ratio will result in a negative cash flow
situation raising the risk of the loan for the lender. DCR's are set
by property type and what a lender perceives the risk to be. Today,
apartment properties are considered to be the least risky category
of investment lending. As such, lenders are more inclined to use
smaller DCR's when evaluating a loan request. Make sure that you are
familiar with a lender's DCR policy prior to spending money on an
application. Ask them to give you a preliminary review of the
investment property that you want to purchase. Information is free,
mistakes are not.
Loan to
Value
Unlike residential
lending, commercial investment properties are viewed more
conservatively. Most lenders will require a minimum of 20% of the
purchase price to be paid by the buyer. The remaining 80% can be in
the form of a mortgage provided by either bank or mortgage company.
Some commercial mortgage lenders will require more than 20%
contribution towards the purchase from the buyer. What a bank/lender
will do is subject to their appetite and the quality of the buyer
and the property. Loan to value is the percentage calculation of the
loan amount divided by purchase price. If you know what a lender's
LTV requirements are, you can also calculate the loan amount by
multiplying the purchase price by the LTV percentage. Keep in mind
that the purchase price must also be supported by an appraisal. In
the event that the appraisal shows a value less then the purchase
price, the lender will use the lower of the two numbers to determine
the loan that will be made.
Credit
Worthiness
For businesses less
than three years old, personal credit of principals will be
evaluated. This may hold true for longer periods of time for tightly
held companies. For corporations, business performance and credit
ratings will be evaluated with a proven track record.
Property
Analysis
Fair Market Value and Fair Market Rent will be analyzed. Special
use property may require additional underwriting. Age, appearance,
local market, location, and accessibility are some other factors
considered.
Most of real
estate lending can be boiled down to the results of three ratios:
- Loan-To-Value Ratio
- Debt Ratio
- Debt Service Coverage Ratio
(DSCR)
The bulk of the energy
spent "processing" a loan is merely an attempt to verify the numbers
that go into the numerator and denominator of the above 3 ratios.
The
Loan-To-Value Ratio (LTVR) is defined as follows:
Loan-To-Value=
Total loan balances (1st mtg+2nd mtg+3rd mtg) / Fair market value
(as determined by appraisal)
Loan-To-Value
Ratios seldom exceed 80% because the lender always want some extra
protection against default.
The second
ratio that lenders use when underwriting a loan is the Debt Ratio.
The Debt Ratio compares the amount of bills that the borrower must
pay each month to the amount of monthly income he earns. More
precisely, the Debt Ratio is defined as:
Debt Ratio = Monthly
Debt Obligations / Monthly Income
Obviously
someone whose Debt Ratio is 150% is in trouble. A Debt Ratio of 150%
would mean that a borrower's obligations are one and a half times
his income. Debt Ratios seldom are allowed to exceed 40% in
practice.
The final ratio
used in lending is the Debt Service Coverage Ratio (DSCR). The Debt
Service Coverage Ratio is a sophisticated ratio only used for large
loans on income producing properties. It is defined as:
Debt
Service Coverage Ratio = Net Operating Income / Debt Service
Net Operating
Income is the income from a rental property after deducting for real
estate taxes, fire insurance, repairs, and all other operating
expenses; and Debt Service is the mortgage payment on the property.
Most lenders insist that this ratio exceed 1.0. A debt service
coverage ratio of less than 1.0 would mean that the property did not
produce enough net rental income for the owner to make the mortgage
payments without supplementing the property from his personal
budget.
Commercial Loan to Value Ratios
The loan-to-value (LTV) ratio is probably the most
important of the 3 underwriting ratios
The
loan-to-value (LTV) ratio is probably the most important of the 3
underwriting ratios.
The
loan-to-value ratio is defined as:
LTV Ratio = Total Loan
Balances (1st mtg+2nd mtg +3rd mtg) / Fair Market Value of the
Property
First let's
look at the numerator. If the borrower is only applying for a first
mortgage, and there will be no other loans on the property, then the
beginning balance of the new loan requested should be inserted in
the numerator.
However, if the
borrower is applying for a second mortgage, then the "underwriter"
(the person who determines whether or not the loan qualifies) should
insert the sum of the first and second mortgages in the numerator.
Similiarly, if the borrower is applying for a third mortgage, then
the underwriter should insert the sum of the first, second and third
mortgages into the numerator.
When the
borrower is applying for a second or third mortgage, the
loan-to-value ratio is often known as the combined loan-to-value
ratio (CLTV ratio).
Now let's look
at the denominator. Generally the fair market value of a property is
determined by an appraisal. There is one important exception,
however. When the proceeds of a mortgage loan are used to buy the
same property that is securing the loan, then that mortgage is known
as a "purchase money loan." If the appraisal comes in lower than the
purchase price in a "purchase money" transaction, then the lender
will use the LOWER of the purchase price or appraisal.
Mortgage
brokers are often asked by real estate agents and buyers to base
their loan on the appraised value rather than the purchase price.
Their claim is that they have negotiated a super deal and that the
property is worth much more than what they are paying for it. This
may be so (although generally untrue), but lenders always base their
maximum loan on the lower of purchase price or appraisal. The
lender's argument (its their money, so there is really very little
argument) is that an appraisal is really no more than an estimate of
fair market value, no matter how competent or conscientious the
appraiser may be. The only true indicator of value is the
marketplace in which "a willing buyer and a willing seller, each in
full knowledge of the salient facts, and neither under undue
pressure, agree upon terms." If the property sells for "X," then it
is probably only worth "X."
