The landscape for commercial mortgage lending continues to evolve. From stated-income to owner-user, high loan to value (LTV) to negative debt-service-coverage ratio (DSCR), today’s commercial loan programs accommodate more borrowers and more unique lending scenarios than ever before.
Commercial borrowers are becoming more sophisticated and more demanding. Local banks, whose traditional loan structure boasted a three- to five-year term with a reset, are now challenged by an array of loan programs offered by an army of mortgage brokers in most major U.S. markets.
While the landscape continues to widen, the fundamentals of commercial mortgage loan origination, underwriting and risk aversion remain consistent. There are some common, yet paramount techniques for originating commercial loans from the lender’s perspective. Following these steps will help you work better, not harder, and can increase your loan-closing ratio. The ultimate goal is to help your borrowers maximize the loan amount and to make it easy for lenders to do so.
Underwriting cash flows
Originating commercial mortgages begins with an understanding of what creates value in income-producing properties. Commercial lenders concentrate primarily on the physical real estate — and specifically on the income it produces. Therefore, proper development and prudent analysis of an operating statement is paramount to underwriting.
The operating statement measures a property’s income and expenses. It includes the following information:
- Potential gross income: The potential income a property may generate at 100-percent occupancy (which includes potential income from vacant space at market rent) before expenses
- Effective gross income: The anticipated income a property may generate after adjustments for vacancy and collection loss and other adjustments including mark-to-market
- Net operating income: The anticipated income remaining after all operating expenses but before tenant-improvement costs, leasing commissions, capital expenditures, annual debt service and book depreciation
- Net cash flow: The anticipated income remaining after all operating expenses including tenant-improvement costs, leasing commissions and capital expenditures but before annual debt service and book depreciation
- Operating expense ratio: The ratio of operating expenses to effective gross income
Normalizing income and expenses
Operating statements vary considerably. Because of the disparate formats of operating statements, it is recommended that brokers reconstruct the borrower’s operating statement. You can do this by reconstructing a standardized operating statement from the borrower’s statement or property-tax return that includes a breakdown of all income and expenses specifically related to the real property.
It is important to collect and report income and expense information for at least one year, preferably the most recent full year, and to include a year-to-date statement. The potential gross income on the cash-flow analysis should match the one calculated from the rent roll. If it doesn’t, it must be reconciled.
An appropriate vacancy factor should be applied to the potential income to arrive at the estimated gross income. Move unusual and nonrecurring expenses (e.g., tenant-improvement and leasing-commission [TILC] costs, replacement reserves, extraordinary capital expenditures, etc.) below the net-operating-income (NOI) line. Adjust the expenses to compensate for expense inflation before calculating net cash flow.
Subtract the appropriate vacancy and collection loss from the potential gross income to arrive at the effective gross income. Then account for and normalize the property expenses — adjusted for inflation — and apply the appropriate underwriting fees and reserves to calculate net cash flow.
Commercial appraisers estimate market value with the income-capitalization approach, which is NOI divided by the direct capitalization rate. The sales-comparison and cost approaches are developed to support the findings in the income approach. The cap rate is associated with the overall risk of the property — the lower the risk, the lower the cap rate. For scenarios where a market-driven cap rate is unknown, apply a standard cap rate based upon the property type, adjusted for the overall risk.
When normalizing operating statements, it is especially important to interrogate the items that are included in the repair and maintenance line. Repair and maintenance items include all recurring expenses necessary for general repairs and maintenance including common areas and building upkeep. These items are expensed above the NOI line. Nonrecurring items, such as replacing a roof, heating, ventilation and air conditioning, plumbing or other major building systems, are expensed below the NOI line. Expenses that appear above the line are normalized, and expenses below the line are not. This allocation can have a significant effect on underwritten NOI.
Calculating maximum loan amount
Generally, commercial mortgage loans are constrained by two calculations: 1. Maximum loan at maximum LTV; and 2. Maximum loan at minimum DSCR, where LTV and DSCR are inversely proportional.
LTV is calculated by dividing the requested loan amount by the estimated property value. If the direct capitalized value is insufficient to cover the requested loan amount, the loan amount will be constrained by the LTV.
The DSCR is calculated by taking the net cash flow divided by the annual debt-service payments at the requested loan amount. If the net cash flow is insufficient to cover the requested loan at the target DSCR, then the loan amount will be constrained by the minimum DSCR.
Here’s how to calculate the maximum loan amount with each calculation:
- Maximum LTV approach: Apply an appropriate cap rate to the net cash flow to estimate the direct capitalized value. Apply the maximum LTV to the direct capitalized value to calculate the maximum loan at maximum LTV.
- Minimum DSCR approach: Divide the net cash flow (after reserves for TILC and capital expenditures) by the annual debt service, then constrain by the minimum DSCR.
Analyze the underwritten reserves and constraints to determine if the underwriting supports the loan request. Make adjustments to the underwriting based on the attributes of the property, the market and other considerations.
Maximizing the loan amount
Assume a loan request of $1.25 million to refinance an office property. Based on the direct capitalized value, an 80-percent LTV will support a loan amount of $1 million. Therefore, based on the existing underwriting, the property does not generate enough income to support the loan request.
To relieve the maximum LTV constraint, you must adjust and reconcile the underwriting parameters. By modifying certain underwritten reserves (such as management fees, vacancy and TILC), you decrease the overall expenses, thereby increasing the net cash flow. Applying the same cap rate to the higher net cash flow will result in a higher direct capitalized value. This results in a lower LTV and a higher loan amount.
When the loan is constrained by LTV or DSCR, be sure to assess whether the potential gross income is calculated correctly. Include any rental increases (escalations) stated on a lease agreement if the increase is scheduled to occur within two to three months of the underwriting.
Look at whether all nonrecurring or unusual expenses have been moved below the NOI line on the operating statement. Expenses above the line should be normalized and adjusted for inflation. Expenses below the line are typically not adjusted for inflation. Moving nonrecurring repair and maintenance expenses (above the line) to nonrecurring capital expenditures (below the line) will typically increase the net cash flow.
Common adjustments to underwriting guidelines may include the following:
- Vacancy and collection loss: Generally apply the greater of the actual vacancy, the market vacancy or the vacancy underwriting guideline.
- Management fee: Generally apply the greater of the actual management fee (according to the property-management agreement), the market-rate management fee or the minimum management fee underwriting guideline.
- Capitalization rate: As cap rates are a function of the relative risk of the investment, the lower the cap rate, the higher the value.
- Replacement reserves for capital expenditures: This expense is the minimum required underwritten cost for replacement reserves (or capital expenditures) and is different from repairs and maintenance. The amount is based on many factors including property type, loan amount, and many physical, financial and tenancy factors identified in the proposed loan.
- Tenant improvement and leasing commissions: This amount is also based on many factors, including property type, loan amount, and physical, financial and tenancy factors identified in the proposed loan. Combined, the annual projected cost of TILCs are deducted from the net operating income before determining the net cash flow available for debt service. Use the greater of the actual, historical or the underwritten guideline for TILC.
For a commercial lender to provide a loan quote or term sheet, the broker’s commercial loan-submission package should include the following:
- Executive summary and property description
- Current rent roll (with start and end dates, contract rent and market rent)
- One to two years’ income and expenses (plus year-to-date)
- Borrowers’ personal financial statement and credit report
- Color photos of the property
Without this information, a lender likely will be unable to analyze the property’s cash flows and calculate NOI accurately. Therefore, without the necessary information, neither the loan amount nor the interest rate may be quoted reliably. It is prudent at this stage to manage the borrower’s expectations in regard to loan proceeds and interest rate. Avoid bait-and-switch tactics.
Some wholesale commercial lenders offer a broker rebate, which is tantamount to yield-spread premium. Some small-balance lenders allow brokers to earn as many as four or five points on a transaction. These lenders typically lend on hard-to-place loans or loans that require a particular niche. Typically, loans with one point are more competitively priced.
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Mortgage brokers are generally compensated for their ability to collect and analyze data, their professionalism in demonstrating the property’s main underwriting issues, and their ability to justify and support compensating factors regarding the loan underwriting. To increase your closing ratio, take the time to collect the required data, to analyze the data accurately and to present the data to the lender clearly.