How to Borrower $50,000,000: The Commercial Mortgage Underwriting Process

Posted on November 20, 2007
Filed Under Business & Entrepreneurship, Finance & Economics |

When applied to commercial real estate debt, underwriting is a term used to describe the process a mortgage originator goes through when deciding whether or not to issue credit to a borrower.  Financing commercial real estate is a completely different game than residential mortgage financing, and knowing how the process works will most certainly work out to your advantage. 

Commercial real estate financing is different than residential debt for many reasons.  For example, residential loans largely deal with the borrower’s capacity to repay and ignore any income potential of the property (there usually isn’t any).  On the other hand, the underwriting of commercial real estate places most of the analysis on the income potential of the property, while the guarantors or sponsors of the project are secondary.  This is not to say that that the borrower doesn’t matter, but if a property is sufficiently lucrative on the basis of its income potential alone, then the loan will most likely get approved even if the borrower is weak.

Before we move on one important distinction in commercial real estate debt needs to be made.  And that is between construction loans and permanent loans.  Construction loans are used to finance the construction of a real estate project, which could include a large master planned community or an income producing building.  After the project is built, the construction loan is paid off, either by the sale of homes, the sale of the building, or the refinance of the building by a permanent market lender.  Permanent financing, on the other hand, is long term financing designed for buildings that are already built and stabilized.

Underwriting Criteria
The good news about commercial real estate financing is that most of the underwriting criteria are fairly standardized.  And once you know what a lender is going to look at, you can do that analysis yourself before you present a loan package, which will significantly strengthen your bargaining position. 

Although the bulk of the analysis will focus on the property itself and the market, it is important to know what to expect as a guarantor on a loan.  This usually doesn’t apply in permanent market financing, but is especially relevant in construction lending. 

The typical laundry list a construction or mini-permanent lender will look for include:

• Personal financial statements including contingent liabilities (signed and dated),
• Personal real estate schedule including property location, status, outstanding loan balance and debt service coverage
• The last two years of personal income tax returns including schedule K-1 distributions and current income tax extensions if relevant
• Credit History (the lender will pull a credit report on your and any other guarantors).

Mostly what the underwriter is looking at in his analysis is the financial strength of the sponsor.  They will take your financial statement and spread them onto a standardized software program or excel worksheet in order to better understand your financial health.  If you list out a number of real estate developments or business interests for example, then the lender will want to get a good feel for what those include, and the current status of those projects.  Also, the underwriter will want to make sure you have enough liquidity or interest reserve built into the projects to carry the debt service should the need arise.  The lender will also calculate a number of ratios such debt to worth (liabilities divided by net worth), and debt to income (all debt service requirements divided by total sources of income).

Property Level Underwriting Criteria
Loan to Value (LTV).  This is a basic measure of the contractual principal loan amount divided by the property’s market value (usually established by the appraisal).  The actual LTV will largely depend on the risk of the product type.  Raw land, for example will see a much lower LTV than an apartment complex since raw land is a riskier product (there is no income potential).

Loan to Cost.  This is the contractual loan amount divided by the cost of the project.  This is mostly relevant in construction lending where the actual cost of the project may differ significantly from the value of the project.  Please note that it is typical for a lender to provide a loan amount of the lesser of the LTV or LTC.  For example, a loan covenant might state something like ‘to provide funds for the finance of a retail shopping center in the amount of the lesser of 75% LTV or 80% LTC.’

Debt Service Coverage Ratio. While the LTV is an asset based underwriting criterion, the DSCR is an income based underwriting criterion.  The debt service coverage ratio is the property’s Net Operating Income (NOI) divided by the annual debt service required by the loan.  Typically a DSCR of 1.2 is standard, however this will also change based on the risk of the property.  The DSCR is an easy way to measure the cushion available to the lender, should the property experience a higher vacancy than projected or lower rents. 

Break Even Ratio.  The BER is the annual debt service requirements on the loan plus the property’s operating expenses, divided by the potential gross income.  This measure gives the percentage occupancy of the property needed to cover all the expenses associated with the property.  Sometimes the lender will look at this including the market vacancy rate as well to be even more conservative.

In addition to the above measure and the items needed from the personal guarantors, these items are typically needed as a part of the lenders due diligence process:

• Phase I environmental report indicating no contamination of the site
• Budget (if new construction)
• Operating Pro-forma (if new construction)
• Operating statements (if already constructed and leased up)
• Organizational documents (if a single asset entity)
• Plan and cost review and/or property inspection report
• Full narrative appraisal

Depending on the type of property you are trying to finance, there may be some other relevant items required, but those are they typical ones.

Other than these basic guidelines for underwriting commercial real estate mortgages, it is very important to note that this industry is built on relationships.  If you operate as a developer or investor in a local market, you already know that no matter how big the city is, the real estate community is small and after a few years people know who you are. 

Lenders don’t like spinning their wheels and would much rather work with you over the long-term than just on one or two deals.  This is beneficial for both parties and more often than not the lender will be willing to bend a few rules and make a few exceptions for repeat customers.  Just something to keep in mind.

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