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:
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 will 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 who’s 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.