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 Is Commercial Property Underwriting
The Key To Securing Property Financing?


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

Less: Expenses

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

Utilities                                                                         $120,000

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

Note the difference that LTV AND LTC Financing Makes 
MAI Appraised Value = $1 Million Dollars
Purchase Price = $500k
Equity = $500k
Purchase Price = 50% of $1Million


 LTV 80%  $1Million $800k +$300K Cash Back At Closing
 LTC 80% $500K $400k $100K Cash Required
To Close
There is a BIG difference in using LTV and LTC financing.

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.
It adds such a valuable part to the transaction that the brokers’ time involvement is minimal. A primary benefit is that it tells prospective buyers how much financing potentially is available for a property before submitting it to any funder. This helps the Seller to validate his asking price and to qualify the Seller before entering into any contracts.

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.
By having your properties pre-unwritten opens new avenues and options that simply aren’t available with other financing.
When you consider that a pre-underwritten proposal can make the difference in securing a recourse or non-recourse loan   or a LTC vs. LTV  financing, it’s well worth the cost.

Here are a few more benefits to having a property pre-underwritten:   

1. Most importantly, a pre underwritten proposal separates your package from hundreds of others because it is very rare. Because of this, your proposal gets the lenders immediate attention because it’s exceptional and out of the ordinary.
 
2. A pre underwritten proposal gives you the opportunity to identify any weaknesses in your proposal before submitting it to the Lender. You can address the weakness prior to submitting your proposal thereby eliminating the possible and obvious weaknesses in the proposal prior to submitting it to the lender.
 
3. A pre underwritten proposal illustrates your attention to detail and illustrates that you have given great thought and consideration about your project and have invested time and resources in preparing your proposal.
   
4. A pre underwritten proposal makes it easier to negotiate with the Lender and to enter into a constructive dialog based on your numbers rather than speculations. Additionally, you can use this report to negotiate with the property seller by sharing the report and explaining that the property simply can’t meet the underwriting guidelines at the current price and will require a reduction in the price to meet the underwriting guidelines.
   
5. A pre under written proposal is simply easier for a Lender to analyze and speeds up the process. Thus, your replies will be much faster because it’s simply easier for the lender to analyze your proposal. Without the report it could take weeks for the Lender to access your proposal because most proposals are very fragmented and require time to go through all the data to locate the data needed. With a underwriting report, all the data is available in a single file. 
 
6. A pre underwritten proposal makes your negotiations with the Lender easier because all of the information the Lender needs is available. You can offer the lender form or back end equity, negotiate for higher LTV’S, and get moratoriums on payments and more. The doors of opportunity are easier to enter with a quality package. 
 
7. A pre underwritten proposal can be used to negotiate with a Seller for a lower price or better terms.
“According to my underwriters, the property is only worth $$$$$$, here’s a copy of the underwriting report for you to review”.
Additionally, as a property seller, the underwriting report can eliminate any negotiations and put you in a position to establish to your Sellers that the property is worth your asking price thereby eliminating the need for any price negotiations.If you are the Buyer and decide to walk away from a property, you can offer to Sell your report to the Seller. He can us it to establish value and to assist in the Selling of his property to the next potential Buyer.
 
8. A pre underwritten proposal loan package identifies you as a serious and professional borrower.
 
9. A pre underwritten proposal shows you and the strengths and weakness of your proposal before submitting it. In most case, if the numbers aren’t working there are basically 2 things to ask the seller to do.

1. Ask the seller to show more income.

2. Ask the Seller needs to show less expenses.

If the Seller can’t show more income or less expenses, offer less for the property. This is the power of a pre-underwritten property.

   
10. You only get one time to make a first impression. A Professional proposal makes your first impression your best impression!

Sample Report Here