Understanding Commercial Real Estate Underwriting

You kept an eagle eye on commercial real estate listings. You found and toured a property that’s perfect for your business or investment portfolio. You’re ready to take the next step and make it yours.

You’ll likely need a real estate loan to do so, whether you’re a first-time commercial real estate buyer or a seasoned investor. Before approving loans, lenders evaluate risk. They determine if giving you a loan is the right call through a process called underwriting.

How can you get a commercial loan? What do lenders consider before granting real estate loans? Which loan applications get the seal of approval?

When you apply for a commercial loan, the lender takes your credit history and net operating income into consideration, along with the value of the property you want to buy.

Learn more about what commercial lenders look for during underwriting, so you can better position your loan application.

What is Commercial Real Estate Underwriting?

Underwriting has a fun history. The process was created by Lloyd’s of London, an insurance broker, in the 1600s. At the time, underwriting divided the risk for harrowing sea voyages. Today, the commercial underwriting process helps evaluate financial risk—for purchases on land, not at sea.

If you’re applying for a real estate loan, your request will be approved or denied based on how risky it is to lend you money. Will you make enough to repay the loan? Is the property in question worth the investment? Commercial real estate underwriting doesn’t only look at the borrower. The underwriter will also evaluate the property.

What Underwriters Analyze

An underwriter’s job is to determine whether to approve or deny the loan. To calculate the risk involved, the underwriter analyzes the borrower’s financial documentation, orders a property appraisal and ensures there are no other claims on the title.

If you’re the borrower, lenders will check your:

  • Cash flow statements
  • Credit score
  • Credit history
  • Net worth
  • Property value

If a lender asks for additional information, it’s important to provide it in a timely fashion. A low credit score, large amount of debt or previous bankruptcy may harm your chances of receiving a loan. Be prepared to disclose these things to the lender and have an explanation ready.

How Lenders Determine Viability

As a borrower, the property is an investment in your business and future. Similarly, commercial lenders look at you and your property as an investment. Before they approve your loan, they need to be sure you will be in a position to repay it. Lenders use several calculations and ratios to forecast the return on the loan and reveal if the property is a sound investment.

Net Operating Income (NOI)

The net operating income (NOI) determines the income the property will produce in one year. Start with your gross income, then subtract your operating expenses like maintenance, property tax, utilities and CAM fees.

Underwriters may include adjustments to account for tenant vacancies for multi-tenant properties. These adjustments are vacancy allowances, and they make the NOI estimate more realistic. Additionally, adjustments may be made for bad debt expenses, which account for the chance that tenants will default on rent.

Cap Rate

Lenders calculate the cap rate to determine the return on the property. Cap rates are return percentages based on future income.

Cap Rate = Annual NOI / Purchase Price

Lower cap rates of 3 to 6% generally show that the purchase is expensive for the borrower. Higher cap rates of 7 to 10% indicate that the purchase is more affordable for the borrower. Cap rates are a reflection of the product type, local market conditions, risk tolerance of the buyer and alternative investment options.

Loan-to-Value Ratio (LTV)

How do lenders set loan amounts? The National Association of Realtors found that 60% of lenders use the loan-to-value ratio to determine loan amounts. The remaining lenders use the debt-service coverage ratio or a combination of the two.

The loan-to-value ratio (LTV) compares the size of the loan and the value of the property. Finding the LTV is simple. Lenders divide the amount of the loan by the property’s value.

LTV = Loan Amount / Property Value

For example, let’s say you would like a $400,000 real estate loan for a property appraised at $650,000. The LTV would be 62%.

Commercial lenders like to see LTVs between 65 and 85%. However, this can vary depending on the type of commercial real estate. Generally, a lower LTV increases your chance of being approved for a loan

If a lender already has a set LTV percentage in mind, they can calculate the loan amount by rearranging the equation from above.

Loan Amount = LTV % x Property Value

A lender wants to offer 70% LTV for a property worth $650,000. With this LTV percentage, the loan you would receive from the lender would be $455,000.

Debt-Service Coverage Ratio (DSCR)

Will the property’s income be enough to repay the debt? The debt-service coverage ratio (DSCR) answers this million-dollar question. Lenders look at this ratio to determine the amount they can lend. If they don’t use this ratio, the lender will use a loan-to-value percentage.

The DSCR takes a property’s net operating income and divides it by the annual mortgage.

DSCR = NOI / Annual Mortgage

Let’s put the ratio in action. Take this example. A property with a NOI of $135,000 and an annual mortgage of $100,000 has a DSCR of 1.35. The DCR of 1.35 represents a net operating income that is 35% higher than the debt service payment.

A higher DSCR is better. Lenders look for a DSCR of 1.25 or 1.5 and higher. The higher the number, the lower the risk that the borrower will default on the loan. If a borrower’s DSCR is less than 1, they won’t be able to pay back the loan. The property’s income won’t be enough.

The National Association of Realtors 2019 commercial lending report found that the median DSCR was 1.25. Retail malls had the highest DSCR (at 1.28), followed by suburban offices and warehouses (each at 1.25). Land purchases had the lowest DSCR (at 1.20).

Checking in on the Property

Underwriting’s two goals are to determine if someone is a viable candidate for a loan and calculate a maximum lending amount. Underwriters analyze your financial history and potential, but that’s not all they do.

A lender’s team ensures the property is a worthwhile investment. After all, the property is collateral against the loan. During the commercial underwriting process, a lender will do the following:

  1. Request an appraisal. An appraisal tells the lender the market value of the commercial real estate property in question.
  2. Conduct a title search. The lender will ensure no one else is on or has claims to the title.
  3. Check the property’s vulnerability. The lender will see if the property is susceptible to natural disasters, flooding and fire.

Tips for Commercial Loan Applications

No matter how you prepare, there’s no guarantee your loan application will be approved. The best you can do is complete your application fully and honestly. Then discuss potential hiccups with the lender.

Lenders have different commercial loan requirements, so be sure you fit the bill before applying. For example, the Small Business Administration’s microloans can’t be used to purchase real estate.

If you’re applying for a commercial loan, here are some tips to put your best foot forward:

  • Provide the lender with what they need. Give the lender all the documentation, reports and answers they request promptly. Don’t try to leave information out or beat around the bush with your answers. Be genuine and honest.
  • Get the property appraised. The underwriter needs to know the property’s value. You can kick-start the underwriting process by ordering a property appraisal and attaching the report to your loan application.
  • Sell yourself and the property. Does the property have potential? Where will you be in the future? How do you plan to grow? Map out these details and tell the lender. In your application and discussion with lenders, share your vision and describe development opportunities.
  • Make your goals crystal clear. The more you can define your goals, the better chance you can gain favor with a lender. Be clear and precise when explaining your goals and include how you plan to achieve them.

After the underwriting process is complete, you’ll be approved for a loan or denied one. If denied, the lender will tell you why.

Before you think about loans, you need to find your investment property. A commercial real estate broker helps you discover property that suits your business or investment goals.

Contact Commercial One Brokers. Our experienced team is here for you, whether you’re interested in retail, restaurant, office or industrial space. Reach out to learn more about available commercial real estate listings for lease and purchase in Branson, MO.

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