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Underwriting
Guidelines
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.
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Three Ratios
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 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 whose 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.
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LTV Ratio
The loan-to-value (LTV) ratio is
probably the most important of the 3 underwriting ratios.
The loan-to-value ratio is defined as:
LTV Ratio = Total Loan Balances (1st mtg+2nd mtg +3rd mtg) / Fair Market
Value of the Property
First let's look at the numerator. If the borrower
is only applying for a first mortgage, and there will be no other loans on
the property, then the beginning balance of the new loan requested should
be inserted in the numerator.
However, if the borrower is applying for a second
mortgage, then the "underwriter" (the person who determines whether or not
the loan qualifies) should insert the sum of the first and second mortgages
in the numerator. Similarly, if the borrower is applying for a third
mortgage, then the underwriter should insert the sum of the first, second
and third mortgages into the numerator.
When the borrower is applying for a second or
third mortgage, the loan-to-value ratio is often known as the combined
loan-to-value ratio (CLTV ratio).
Now let's look at the denominator. Generally the
fair market value of a property is determined by an appraisal. There is one
important exception, however. When the proceeds of a mortgage loan are used
to buy the same property that is securing the loan, then that mortgage is
known as a "purchase money loan." If the appraisal comes in lower than the
purchase price in a "purchase money" transaction, then the lender will use
the LOWER of the purchase price or appraisal.
Mortgage brokers are often asked by real estate
agents and buyers to base their loan on the appraised value rather than the
purchase price. Their claim is that they have negotiated a super deal and
that the property is worth much more than what they are paying for it. This
may be so (although generally untrue), but lenders always base their
maximum loan on the lower of purchase price or appraisal. The lender's
argument (its their money, so there is really very little argument) is that
an appraisal is really no more than an estimate of fair market value, no
matter how competent or conscientious the appraiser may be. The only true
indicator of value is the marketplace in which "a willing buyer and a
willing seller, each in full knowledge of the salient facts, and neither
under undue pressure, agree upon terms." If the property sells for "X,"
then it is probably only worth "X."
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When analyzing the personal
budget of a borrower, lenders use two different debt ratios to determine if
the borrower can afford his obligations. These two debt ratios are:
- Top Debt Ratio
- Bottom Debt Ratio
The "top" debt
ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income
By "monthly housing
expense" we mean either the borrower's monthly rent payments, or if
she owns her own home, the total of the following -
Monthly Housing Expense
- 1st mortgage payment on
home plus
- Real estate taxes (annual
cost/12) plus
- Fire insurance (annual
cost/12) plus
- Homeowner's association dues (if
home is a condo or townhouse) plus
- Second mortgage payment
(if any) plus
- Third mortgage payment (if
any).
You will often hear the term
P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance.
While P.I.T.I. is not exactly the same as Monthly Housing Expense because
it does not include homeowner's association dues, the two terms are often
used interchangeably.
Lenders have learned over
the years that a borrower's "top" debt ratio should not exceed
25%. In other words, a person's housing expense should not exceed 1/4 of
his income. While lenders will often stretch this number to as high as 28%,
traditional lending theory maintains that anyone with a debt ratio in
excess of 25% stands a good chance of developing budget problems.
The second ratio that
lenders use to determine if a borrower can afford her obligations is the
"bottom" debt ratio. It is defined as follows:
Bottom Debt Ratio = (Total Housing Expense + Debt Payments)/Gross Monthly
Income
The only difference between
the two ratios is the inclusion in the numerator of "debt
payments." Debt payments include the following:
Debt Payments
- Car payments
- Charge card payments
- Payments on installment
loans, for example - a payment on a washer & dryer that the borrower
purchased.
- Payments on personal
loans, for example - a signature loan from the borrower's bank.
What is not included in
"debt payments" is Utilities such as PG&E, water or telephone
and payments on real estate loans. Real estate loans are usually offset
first by the net rental income from the property. If the borrower has a net
positive cash flow from all his rentals, then the net income is usually
added to his "gross monthly income." If the borrower has a net
negative cash flow from all of his rental properties, then the amount of
the negative cash flow is usually added to the numerator of the
"bottom" debt ratio as if it were a monthly debt obligation, like
a car payment.
Traditional lending theory
maintains that a borrower's "bottom" debt ratio should not exceed
33 1/3%. In other words, the total of the borrower's housing expense and
debt obligations should not exceed 1/3 of his income. Lenders often will
stretch on this ratio to as high as 36%, and some have even been known to
stretch as high as 40% or more. Obviously a loan with a debt ratio of 40%
is a far more risky loan than a loan with a debt ratio of 32%.
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The most important ratio to
understand when making income property loans is the debt service coverage
ratio. It is defined as:
DSCR = Net Operating Income (NOI) / Total Debt Service
To understand the ratio it
is first necessary to understand the numerator and the denominator. Let's
take a look at net operating income (NOI) first.
Net operating income is the
income from a rental property left over after paying all of the operating
expenses:
Gross Scheduled
Rents
$100,000
Less 5% Vacancy & Collection Loss $5,000
________
Effective
Gross
Income:
$95,000
Less Operating Expenses
Real Estate Taxes
Insurance
Repairs & Maintenance
Utilities
Management
Reserves for Replacement
Total Operating
Expenses:
$30,000
Net Operating Income
(NOI) $65,000
Please note that lenders always insist on some sort of vacancy factor
regardless of the actual vacancy rate in an area to cover collection loss.
In addition lenders always insist on using a management factor of 3-6% of
effective gross income, even if the property is owner-managed. Their logic
is that they would have to pay for management if they took back the
property. Finally, NOTE THAT WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN
OPERATING EXPENSE.
Next let's look at the
denominator, Total Debt Service. This includes the principal and interest
payments of all loans on the property, not just the first mortgage. NOTE
THAT WE HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted
for above when we arrived at net operating income (NOI).
To calculate the debt
service coverage ratio, simply divide the net operating income (NOI) by the
mortgage payment(s). For the sake of simplicity, let us assume that there
is only one mortgage on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139
Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14
Obviously the higher the
DSCR, the more net operating income is available to service the debt. From
a lender's viewpoint it should be clear that they want as high a DSCR as
possible.
The borrower, on the other
hand, wants as large a loan as possible. The larger the loan, the higher
the debt service (mortgage payments). If the net operating income stays the
same, and the loan size and therefore the debt service increases, then the
lower the DSCR will be.
Life insurance companies are
very conservative and generally require a 1.25 or 1.35 DSCR. This means
that their loan-to-value ratios are low. Savings and loans (S&L's)
generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low
as 1.10.
A DSCR of 1.0 is called a
breakeven cash flow. That is because the net operating income (NOI) is just
enough to cover the mortgage payments (debt service).
A DSCR of less than 1.0
would be a situation where there would actually be a negative cash flow. A
DSCR of say .95 would mean that there is only enough net operating income
(NOI) to cover 95% of the mortgage payment. This would mean that the
borrower would have to come up with cash out of his personal budget every
month to keep the project afloat.
Generally lenders frown on a
negative cash flow. Some lenders will allow a negative cash flow if the
loan-to-value ratio is less than around 65%, the borrower has strong
outside income such as an electronic engineer, and the size of the negative
is small. Lenders rarely allow negative cash flows on loans over $200,000.
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Listed below is a partial list of properties that
require commercial financing.
| Multifamily |
Industrial |
Office |
- Garden Apartments
- Hi-Rise Apartments
- Mid-Rise Apartments
- Low/Mod Income
- Student Apartments
- Senior Apartments
- Underlying Coop
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- Heavy Manufacturing
- Light Manufacturing
- Warehouse/Distribution
- Owner Occupied
- Multi-Tenant
- Self Storage
- Special Purpose
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| Office |
Health
Care |
Retail |
- Single Tenant
- Hi-Rise Tower
- Mid-Rise Office
- Office Over Retail
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- Congregate Living
- Nursing Home
- Rehabilitation
- Ambulatory Care
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- Regional Enclosed
- Strip Center
- Outlet Mall
- Free Standing
- Single Tenant
- Regional Unenclosed
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Questions
to Ask Yourself
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- Are you and your business
credit worthy?
-Your personal and business credit ratings will be
analyzed.
- What kind of money do you
require?
-Short, long, intermediate term money or equity capital.
- How much money do your need?
-Present exactly what you need and what it is for.
- Do you have sufficient
collateral?
-Your collateral must equal the loan amount at a minimum.
- What are the Lender's rules?
-Ask about Loan to Value's and Debt Coverage Ratios.
- What kinds of limitations will
be set by you?
-Know your comfort level with rate, payment, and term
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| Myth: |
It takes
four to six months to get a SBA Loan processed. |
| Fact: |
Completed
loan applications from banks average 10 working days. |
| |
| Myth: |
SBA only
provides free business counseling to business people with SBA loans. |
| Fact: |
SBA
provides free business counseling to all business people. |
| |
| Myth: |
SBA
provides no assistance in helping a business get federal contracts
from the government. |
| Fact: |
SBA
has procurement assistance at Small Business Development Centers
across the country. |
| |
| Myth: |
A business
person can get cheaper interest rates for business loans from SBA. |
| Fact: |
SBA
does not provide lower interest rates for small business people.
Interest rates are negotiable with the bank, but are limited to
2.25% above the prime rate in the Wall Street Journal for loans with
maturities of less than 7 years, and limited 2.75% with maturities
of 7 years or more. |
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| Myth: |
Small
loans are not available through SBA. |
| Fact: |
SBA
provides an incentive to banks to make loans under $50,000 by
reducing their guarantee fee by half. |
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| Myth: |
SBA has no
specialized programs to assist minority business persons. |
| Fact: |
SBA's
8(a) and 7(j) programs provide specialized management and technical
assistance to minorities. |
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| Myth: |
There are
few SBA loan programs. |
| Fact: |
SBA
finance programs provide a wide spectrum of opportunities including
Guaranteed Loan, Handicapped Assistance, Contract Loan, Veterans
Loan, Exported Revolving LOC, and Small Business ($50,000 and less). |
| |
| Myth: |
SBA has no
programs to assist veterans. |
| Fact: |
SBA
gives veterans priority when their loan application arrives in the
office or when they need business counseling to start a small
business. |
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| Myth: |
SBA has
grants to start or expand a small business. |
| Fact: |
SBA
has NO grant program to start or expand a small business. |
| |
| Myth: |
Contractors
receive no assistance from SBA. |
| Fact: |
SBA's
Surety Bond Guarantee Program assists contractors with their Bid
Bond, Performance Bond, and Payment Bond.
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The following
list will help you identify the types of information a banker will need to
make an informed decision about your business.
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Three years
income tax and financial statements
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Year-To-Date
Profit & Loss and Balance Statement
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Personal
Finance Statements
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Projected
Cash Flow Statements for next 12 Months
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Pro Forma
for next 12 Months/Length of Loan
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Federal and
State Taxes Information
-
Collateral
Sheet
-
Well Written
Business Plan
-
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Credit Lines
Under a credit line agreement, the lender supplies a business with
funds intended to fill temporary shortages in cash that are brought
about by timing differences between outlays and collections.
Typically used to finance inventories, receivables, project or
contract related work.
Short-Term
Loans
Used for seasonal build-ups of inventory and receivables. Generally
repaid in a lump sum at maturity, made on a secured basis and are
for a term of a year of less.
Asset Based
Loans
Lender advances funds based on a percentage of your current assets.
The loan is used as source of funds for working capital needs.
Lender typically takes a security position in the assets owned by
the business.
Contract
Financing
Funds are advanced to you as work is performed. Payments by the
contracting party are generally made directly to the lender.
Factoring
Factors actually buy your receivables and rely on their own credit
and collection expertise. Essentially, your customers become their
customers. Factoring is used by firms who are unable to obtain bank
financing. The cost of financing is usually higher than other forms
of S-T financing.
Term Loans
Used to finance your permanent working capital, new equipment,
buildings, expansion, refinancing, and acquisitions. Commercial
banks are the major source of funding. The term of the loan is based
on the useful life of the assets being financed or collateralized.
Your projected profitability and cash flow are two key factors
lenders consider when making term loans.
Equipment and Real Estate Loans
Loans are fully secured by the equipment being purchased. Typically
banks loan 60-80% of the value of the equipment and is repaid over
the life of the equipment.
Lenders make long
term loans secured by commercial and industrial real estate. The
loan is usually made up to 75% of the value of the real estate to be
financed. Repayment terms range from 10 to 20 years. Lenders also
make second mortgages on real estate. The amount of the second
mortgage is based on the appraised market value and the amount of
the first mortgage.
Leasing
Can be accomplished through a bank, leasing or finance company. Your
business will be subject to the same type of review as when seeking
a loan, specifically cash flow of company, value of lease object and
useful life. Lease terms range from 3 to 5 years. At the end of the
lease, there are generally 3 options: purchase, renew and return.
3-15 YR Balloon
loans
Balloon loans offer interest rates that are fixed for a period of
years. Typically these loans are pegged to a treasury index. Terms
are for 3, 5,7,10 or 15 years. The amortization schedules are
generally for 20 or 25 years.
When a balloon loan
matures at the end of the agreed term, the remaining principle
balance outstanding is due at that time. The borrower can pay off
the loan by either selling the property or refinancing. Investment
property is typically owned for a previously defined period of time.
Analyze your investment strategy before securing a balloon. Having
to redo a loan is expensive.
Adjustable rate loans
An Adjustable rate loan will typically fully amortize with no
balloon features. These loans may or may not have adjustment caps.
The rate is determined by an index plus a margin. The indices used
are generally U.S. treasury bond rates. Rates are adjusted at a
certain point in time using either the current rate of the index in
question or the average of the index for the prior year. In either
event, the index used will correspond to the adjustment term. If the
loan is a three year adjustable, then the index used should be the
three year treasury index.
Some adjustable rate
loans are fixed for an initial period of years and then will adjust
after that period. For example a 5/1 adjustable is fixed for the
first five years and there after will adjust each year. The index
used will be the one year treasury rate.
Please note that
commercial lending is not standardized as it relates to programs and
to guidelines. Banks must meet certain federal standards, but the
index, margin, amortization, term and fees are components that are
controlled by the investor based on their risk profit analysis.
Remember that this mortgage will be the greatest expense your
investment property will be responsible for.
As such we recommend
that you consult your real estate agent and your loan officer to
assist in providing you with all the information needed to make a
complete and accurate choice.
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About 30 to 40 days after you file the bankruptcy you will have to attend a hearing presided over by the bankruptcy trustee. This hearing is called the First Meeting of Creditors. At this hearing the trustee will ask questions under oath regarding the content of your bankruptcy papers, assets, debts and other matters. After the trustee is done, your creditors will be permitted to question you.
You should have an attorney there to represent you and your attorney will help you prepare for the hearing. Sometimes, after your hearing is over, various creditors will approach you to discuss the status of secured property or the your desire to retain a
credit card. Your attorney will negotiate with them, with your knowledge and approval.
After this hearing you will normally not need to return to court. However, if a creditor files a motion or an adversary action, most likely you will have to return to court. This is the exception and only your attorney can determine if this is likely to happen.
Disclaimer:
This information deals with Chapter 7 consumer bankruptcy. Each state has its own bankruptcy laws, so you need to check with your state for details. Information dealing with Chapter 13 bankruptcy and consumer debt restructuring is not discussed in the above
FAQs. The information contained in the following FAQs is provided for general information purposes only and is not intended to be a legal opinion nor legal advice nor is it intended to be a complete discussion of all the issues related to the area of Chapter 7 consumer bankruptcy. Every individual's factual situation is different and you should seek independent legal advice regarding specific information.
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