Is Commercial Property Underwriting
What Is Commercial Property Underwriting Anyway?
Almost every day, I am asked why some commercial loan easily approved while others are rejected. or we are asked what’s the key to securing financing for my property, or how can I qualify for a Multi Million dollar commercial acquisition loan.
As a commercial mortgage broker with over 30 years of commercial mortgage lending experience, I have reviewed and underwritten thousands of commercial loan applications. Underwriting is not a mystery – there is a mathematical approach that all commercial mortgage lenders utilize.
Borrowers seeking commercial mortgage loans or apartment building loans to refinance or purchase a commercial property or apartment building need to understand how commercial mortgage lenders value commercial properties and determine cash flow.
Banks and other conventional lenders (as opposed to hard money lenders or bridge lenders) are driven by a commercial property’s ability to generate cash flow and adequately service the anticipated mortgage payments. Understanding the math behind the underwriting will mean the difference between an approval and a rejection.
In order to get started with our analysis, let’s look at a hypothetical apartment building with 50 rental units. The average rental is $1,200 per month. Let’s create and review a sample pro-forma operating statement:
Potential gross income $60,000/month or $720,000/year
Less: Vacancy allowance (say 5%) $36,000
Effective gross income (EGI) $684,000
Management (say 5%) $34,200
Real estate taxes $80,000
Insurance (estimated at $300 per unit) $15,000
Repairs and Maintenance (estimated at $750 per unit) $37,500
Misc. (estimated at 2% of EGI) $13,680
NET INCOME $383,620
In our example, this property has a net operating income of $383,620 after operating expenses (but before mortgage payments). This is the most important number to a commercial mortgage underwriter as this figure will determine the value of the property and the ability of the property to support the mortgage payment. Let’s continue with our analysis:
As outlined above, this property has a Net Operating Income (NOI) of $383,620.
An investor who purchases this property will earn a return of $383,620 on his investment.
What is the relationship between the NOI and the property’s value? The answer will introduce the next concept, which is the Capitalization Rate, or Cap Rate.
The cap rate is the percentage return that an investor expects to earn on his investment.
A bank account today will have less than a 1% cap rate as bank deposits today pay very little interest. A treasury certificate will have a 2%-3% cap rate. Investors investing in real estate should earn higher yields than these safer investments.
A property owner usually expects to earn a return of 5%-10% on his investment depending upon the risk. If an investor earns, say, 8% on his investment, we say that the property has an 8 Cap.
The net operating income is divided by the cap rate to determine the value of the property.
Continuing our analysis of the property above, a property that nets $383,620 and yielding an 8% return on investment will have a value of $4,795,250 ($383,620 divided by 0.08 = $4,795,250).
If the investor is willing to accept a lesser return of, say, 6%, the property is now worth $6,393,667.
As you can see, the lower the expected return, the higher the value. Or said in another way, the more you pay for a property, the lower the return on investment.
Each type of property and each individual market will determine the cap rate used.
For example, a luxury apartment building in Manhattan will have a lower cap rate (and hence be more expensive) than a lower income property in the Bronx. If you are buying an apartment building, make sure you calculate the net operating properly, be knowledgeable about market cap rates (by speaking with knowledgeable local professionals), and determine an appropriate selling price before making an offer.
Once we determine the NOI and the cap rate, we need to calculate the Debt Service Coverage Ratio or DSCR.
The DSCR is the ratio between net operating income and the annual mortgage payments (called Debt Service). Notice that in the example above we did not list mortgage payments as expenses. How much of a mortgage can this property support?
A typical lender will look for a DSCR of 1.25 or better. That means the NOI divided by the Annual Mortgage Payments should be at 1.25 or better. Said differently, the NOI needs to be at least 25% greater than the payments. Let’s illustrate this point:
We start with our NOI of $383,620. Dividing by 1.25 gives us the maximum annual debt service of $306,896 or $25,575 per month. This means that our proposed mortgage payment must not be greater than $25,575 per month. If we use an interest rate of 4.00% and a 30-year amortization, we come up with a maximum loan amount of $5,356,971 as the maximum loan amount an underwriter will consider using the DSCR method. (There are things you can do to decrease the DSRC requirements).
Next, we need to calculate the proposed Loan to Value Ratio or LTV. The LTV is a common ratio that most investors are already familiar with, and is defined as the loan amount divided by the property’s value. Many commercial mortgage lenders will lend up to 80% LTV.
Note: Though many lenders use the term LTV when in reality they mean LTC. This can mean the difference in putting large amounts of cash down verse getting cash back. Let me illustrate this LTV and LTC trick.
The LTV and LTC Difference
Again, illustrating from our example above, if the property appraises at $6,393,667 (using a 6 cap), an 80% LTV will yield a maximum loan of $5,114,934 ($6,3963,667 x 0.80 = $5,114,934).
In most cases the maximum loan calculated by the DSCR method will differ from the maximum loan amount as calculated by the LTV method. The lower number will always be used, and in this case, the maximum loan amount will be as determined by the LTV method at $5,114,934 versus the $5,356,971 as calculated by the DSCR method. In this example, we say that our loan is “LTV constrained” since the loan amount is limited by the LTV and not the DSCR.
There is no mystery when it comes to approving commercial mortgage loans.
Underwriters employ very specific formulas to determine net operating income, cash flow, debt service coverage ratios and loan to value ratios.
Borrowers who understand these calculations and are able to present an accurate loan summary to a commercial mortgage lender stand the best chance of having their commercial mortgage loan approved.
Benefits Of Pre Underwriting
Pre-underwriting gives you the opportunity to identify, address and eliminate any weaknesses in your proposal before submitting it to the lender. Lenders rarely receive pre-underwritten proposals and give them immediate attention because they are very rare exceptions. Most Lenders disqualify 90% of their loan request within minutes because the proposals are incomplete or not packaged correctly. A professionally pre-underwritten loan request will move your loan to the top of the lenders pile of requests. It illustrates your attention to detail and that you have given great thought and consideration about your project and your financing. Your package is like your resume! Quality matters! More importantly, it makes the loan officer’s job very easy. Would you rather have a 5 page resume consisting of different files to look through in search of the information you need, or one file containing all the date you need presented in a simple and strategic manner?
A pre underwritten proposal makes it easier for the loan officer to access you proposal and opens the door to immediate and constructive dialogs with the lender.
Commercial property Underwriting is modeled using the Commercial Mortgage Securities Association’s (CMSA) Investor Reporting Package (IRP) when done correctly and not the conventional conforming underwriting guidelines.
The IRP breaks down the financial reporting guidelines by property type, so that regardless of where a property is located, the manner in which operating performance is analyzed is the same across the board.
This gives you several advantages over all the other applicants in the lender’s financing pool. The lender will take you seriously and see you as a professional. Each commercial loan is approved based on the property’s own strengths and ability to service the debt.
Pre-underwriting isn’t just for investors and commercial buyers but for commercial real estate brokers as well.
Also, the pre-underwriting process validates the asking price. It can be a great advantage for brokers negotiating listing prices with owners who think their properties are worth significantly more than the actual value. Whether it’s commercial property for sale or a construction project it’s worth having.
Loan Packaging Matters
Lenders prefer, even require, that packages be organized in very specific ways so they know in an instant exactly where to go to find each and every detail regarding your proposal. It is what funders understand and allows borrowers to obtain Funding Commitments and LOI’s from lenders in much faster time frames. This saves you critical days in getting your proposals accepted by the lenders and moves you ahead of your competition. I’ve seen investors cut corners and by purchasing a business plan software package thinking is will work for commercial loan packaging and underwriting only to have their projects rejected in hours.
Is Pre-Underwriting Worth The Expense?
Unlike residential investing which is Credit “driven financing”, Commercial properties follow a completely different format.
Here are a few more benefits to having a property pre-underwritten: