Commercial Mortgage Underwriting Through the Eyes of the Underwriter |
By Michael Haltman
When one examines all of the basic factors that go into the initial analysis of a commercial mortgage loan, the following leap to mind: net operating income, capitalization rates and the debt service coverage ratio. After determining that our loan scenario is viable, the next step in the process is to contact the proper lender; thus, initiating one of the most critical parts of getting this loan funded - dealing with the underwriter. Let's take a look.
Getting a borrower to approach you with a commercial mortgage loan scenario is only the first step in the commercial mortgage loan process. Upon your first analysis of the scenario, there are a great many combined factors that will determine if it will ever fund or close. The best borrower and the best property means nothing if due to some error, a careless mistake or a poorly put together loan package there is no closing. Equally, if not more so than residential financing, the commercial mortgage business is extremely relationship-driven, particularly when talking about lenders.
An old adage is that two LO's can bring the same deal to the same lender, and due to something that has or has not happened in the past, or because of the lack of a current relationship, one will get a loan approval and one will not. To help your chances of getting your loans approved, consider the following rules:
Rule 1: Always do what is in the best interest of the borrower, AND in the best interest of the lender. Happy borrowers lead to referral business, and happy lenders lead to your next viable deal getting strong consideration.
Rule 2: Always manage your borrower's expectations when it comes to the potential rate, timing of the transaction and money that is necessary to close a loan. DO NOT tell your clients what you think that they want to hear, tell them the reality. If someone else is over-promising and can't deliver, the borrower will be back. If for some reason they are able to get that better deal, you want to recommend what is in their best interest.
Rule 3: Do not burn bridges with a borrower and the potential referral business they might provide by jamming the wrong deal at them to make a quick dollar.
Rule 4: Do not embellish rent numbers or minimize expense numbers to make a scenario work. This will be caught by an underwriter whose job it is to catch it. The net result will be a rejected loan, and the loss of any relationship with that lender.
Rule 5: Most, if not all, lenders are going to require an appraisal by an independent firm on that lender's approved list. Getting an appraisal upfront before speaking to the lender can be a waste of time and money. Of the different methods that an appraiser will use to calculate the value of a property, the INCOME APPROACH is the key method.
Rule 6: As in anything, a weak foundation or base for a loan package will lead to a relatively high probability of the loan not getting funded because it will never get through underwriting.
Final Rule: Know your lenders, and know for each the type of financing that they do. Never attempt to shove a loan at a lender that is not even close to the lending criteria that they look for. Much of the process comes down to the building to be funded, to the borrower and to the credibility of the person that is bringing the loan to the lender.
Who is the Underwriter?
The underwriter is the representative of the lender whose ultimate job it is to gauge the risk that a specific transaction possesses to go into non-performance. It is his or her job to study every aspect of the loan from the quality of the building, the income stream of that building and the quality of the borrower to determine if the loan fits into the lenders risk guidelines. In order to enhance the potential for loan approval, present the underwriter with the most complete and accurate loan package.
Some of the items they will consider include:- What is the "curb appeal" of the building, or how does it look? In the event of a foreclosure, an ugly building would be harder for a lender to sell than an attractive one, increasing the risk to the bank.
- Who are the tenants and how long are the existing leases? If the tenants' leases are expiring 30 days after the loan closes, that represents more risk to the income stream of the building than a lease that expires in 3 years. What is the quality of the tenant's? If you had a building that had Kmart as a tenant, that would have seemed very strong until they went into bankruptcy and closed locations.
For a lender that had to foreclose on the property and sell it, a space that size is hard to rent out which makes the building harder to sell at the price they need to cover the defaulted loan that they made. A Home Depot with a long term lease as an anchor tenant would score more points with an underwriter than a $1 store. Like an investor in anything, a commercial mortgage lender always has to make a risk-reward judgment.
- Who is the borrower? While the key to a commercial mortgage loan is the net operating income that the building produces, the quality of the borrower does come into play. An underwriter wants to know credit score, and whether the borrower has payment lates, particularly on mortgages. Mortgage lates will be the death knell of a loan for a majority of lenders.
Again, everything is looked at by the underwriter with an eye towards the risk that a loan will present to the lender in terms of default. The greater the risk that a loan possesses, the higher the reward or interest rate that a bank will charge and the more stringent the guidelines of the loan. (i.e. an additional monthly reserve mandated for maintenance if it is felt that the borrower might not have the means if an unexpected repair came up).
Commercial mortgage underwriting is done on a case-by-case basis, because every borrower and property to be financed creates a unique situation. Remember that with commercial borrowers there are typically stories that need to be told, whether it concerns the building, the borrower or both.
It is the commercial property investor or LO's ability to communicate the story effectively, and the willingness of the underwriter to listen with an open mind that matters. These are things that can spell the difference between the successful funding of a scenario versus the death of the deal.
An Underwriter's First Most Important Criteria: Debt Service Coverage
When an underwriter is examining a building with an eye towards financing, one of the first questions that needs to be answered is:
Does this building's income service the loan amount desired with an appropriate level of debt service coverage? In other words, what is the debt service coverage ratio or DSCR of this property given the building's current net operating income (NOI)?
It sounds like a complicated analysis, but it really isn't.
Gross rents - operating expenses = NOI
The operating expenses include property taxes, building insurance, building utilities, 5% of gross rents for vacancy and 5% of gross rents for management of the building.
If at first glance at a property you do not have all of the expense figures, a very ballpark way to determine NOI is to take 1/3 off the gross rents, and the remainder will give a very raw NOI number. This number should not be used with the underwriter, but to do a first glance attempt to determine debt service coverage.
To determine the DSCR the underwriter will use the following formula:
Yearly NOI/Total yearly principal and interest payments for the loan amount
at a given interest rate and amortization period
The typical minimum level for debt service coverage is:
1.2x for multifamily property's
1.25x for other commercial property types
Once the underwriter looks at the result and determines that the number is at a high enough level, case closed and loan approved. Right?
WRONG!
It is now the underwriters' job to take what on the surface seems to be solid financial information, and get down into the numbers to MAKE SURE of the integrity and accuracy of that information.
Consider the risk-reward thinking that goes into a lender's decision based on DSCR. All things being equal, what represents a more attractive loan scenario, strictly according to DSCR:
1.25x coverage or the same building at a 1.35x coverage. Sounds simplistic, but of course the higher coverage is better because it provides more of a cushion for the borrower that has to pay the debt service, and creates a better situation for the lender in the event they have to foreclose and sell the building.
LOAN AMOUNT VS. LOAN TO VALUE
Loan to value or LTV, is not a term that a commercial underwriter really considers when making a determination on the dollar amount of a loan that will be offered for a purchase or a refinance. The key determination is going to be how the income of that building will service the debt of a certain loan amount. Of course other factors, such as an outside appraisal, will come into play when an underwriter is calculating loan amount; DSCR is going to be the key number. Without a coverage ratio at an acceptable level, the other factors will become irrelevant.
For the underwriter, as well as for the investor or borrower to get some idea of the value of the building, and whether it has a good chance to appraise at an appropriate value, the capitalization rate for the given area can be used in conjunction with the NOI of the building. Simply use the following calculation:
NOI/capitalization rate will give you a ballpark value for the building, as long as the two numbers are accurate.
Paperwork Preparation, or The Loan Package
Remember in the beginning we talked about the importance of putting your best foot forward when applying for a loan either for yourself or for a borrower. We talked about having one chance to make a good first impression on the underwriter.
The first step is to know the situation as well as possible so that potential surprises can be avoided (although they will inevitably arise). The second is to make sure that the numbers seem to work for the building as well as the borrower so that the lenders and underwriters time is not wasted with scenarios that have absolutely no possibility of getting funded.
If the minimum credit score for the lender is 600, don't bring a borrower with a 520 that has no stronger guarantor. If the minimum DSCR for a given building type at that lender is 1.25x, don't waste their time with a building and loan amount that will result in a DSCR of 1.05x.
While exceptions can be asked for and sometimes granted for aspects of a loan that might not fit the lenders' specific criteria, use COMMON SENSE underwriting when looking at a potential scenario. You ultimately want to be the person that the underwriter is happy to hear from because they know that the loan scenario you are bringing them will be viable, and not a complete waste of their time.
Not every viable commercial mortgage loan scenario will ultimately get funded, as a wide variety of stumbling blocks can come up un-expectantly throughout the process. The key is to know your scenario inside and out, and build a strong base which will lead to a strong loan package.
General Documents Required for a Commercial Mortgage Loan Package
What is the paperwork that you should be prepared with to provide to the underwriter?- 1003 or loan application
- Credit Report with FICO score (and explanations for any derogatory credit)
- Two years personal tax returns (for a full documentation loan)
- Two years of property tax returns
- Property income and expense statement
- Digital pictures of the property
- Copies of current leases and rent roll
- Schedule of other owned real estate
- Contract of sale for a purchase
- Copy of insurance and utility bills for the building
- Current mortgagor information for a refinance
- Agreement to subordinate to a new first mortgage loan if a current subordinate mortgagor exists in a refinance
Conclusion
The underwriter at the given lender is going to assimilate all of the paperwork provided, and make a determination on its validity and accuracy. If everything is found to fit into the lenders parameters and risk tolerances, an LOI or letter of interest will be given to the borrower. The interest rate and loan amount will be at a level commensurate with the DSCR and perceived risk of borrower and building.
The relationship that you will have with the underwriter on the one hand needs to be professional and hopefully congenial, but it has to be understood that first and foremost they are there to protect the interests of the lender. Exceptions on a specific building or borrower will ONLY be made if it can be completely and satisfactorily explained to the lenders satisfaction.
If all of the steps are followed correctly and accurately, your loan will have the best chance of passing muster and getting ultimate approval. Commercial mortgage financing can at time be a frustrating undertaking due to the nuance and potential pitfalls involved, but can be well worth the effort.
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