Investors who are new to income-producing properties often ask: " How does a commercial lender underwrite a loan?"

It’s a good question, because if one understands how the commercial lender decides on the amount of money he will lend on a commercial property (multi-family properties greater than 4 units included ), a prospective borrower has a chance to assemble a loan package which is attractive to the  lender and thereby improve chances to obtain a good loan.

Loans on individual single family residences (SFR), condos and multi-family properties of 4 units or less, are generally obtained from savings and loan associations, local banks and credit unions. Private lenders, other than sellers, are rarely involved. Underwriters for these loans are interested in the answers to 4 important questions:

  1. Does the prospective borrower have the financial capacity and stability of employment to repay the loan?
  2. What is the fair market value (FMV) of the property which will serve as collateral for the loan?
  3. What percent of the FMV is the requested loan amount?
  4. Does the prospective borrower pay his bills on time?

In the case of the SFR loan (and others in this category) the first question is whether the prospective borrower(s) earns sufficient income and has a sufficient history of steady employment such that the required mortgage payment will not be an unmanageable percent of the gross monthly income.

The residential lender’s second and third concerns pertain to the value of the property which will act as security for the loan. Lenders always envision a scenario in which they become the owners of the property as a result of the borrower’s default. They ask themselves: "How long will it take for me following foreclosure to sell this property at a price which will cover my loan balance and expenses of sale?"

The last criterion judges the borrower’s credit history and pattern of paying debts. This is very important because the first line of defense against loss for the lender is not the amount of equity the borrower has in the property but rather the creditworthiness and credit character of the borrower.

So it is that SFR loan underwriter’s focuses on the borrower and his ability and demonstrated readiness to repay his loan. This is not the case, however, with income–producing properties. Rather than look to the borrower as the first source of repayment for the mortgage, the commercial underwriter looks first to the property and its income.

In order to verify the Gross Operating income from the property the lender will require copies of all leases which will survive the transfer of title. The lender is interested in the quality of the tenant(s), the amount of rent to be paid and the duration of the leases. In a word, he is interested in the quality and durability of the income stream.

In order to calculate the property’s Net Operating Income (NOI) the lender will request a current operating statement showing all operating expenses. The GOI less operating expenses yields the NOI.

The NOI is very important since it is the primary source of cash for servicing the loan. But the commercial underwriter will not lend so large a loan that it would require all the NOI to pay principal and interest. Instead, he will create a cushion for himself but applying a larger Debt Coverage Ratio (DCR), sometimes called the Debt Service Ratio (DSR).

For example, in order to provide a cushion of 25% over the actual cost of servicing the debt, the lender will use a DCR of 125% or 1.25. Therefore he will lend an amount of money such that the NOI of the property divided by annual cost of the loan is equal to 1.25. The reciprocal of 1.25 is 0.80 or 80%. Using a DCR of 1.25, this lender will permit 80% of the NOI to be devoted to debt service.

When the lender perceives a certain property to be riskier (for any number of factors), he will apply a larger DCR and thereby lower the amount of cash earmarked for loan payments. Highly specialized properties may call for a DCR of 1.5 indicating a smaller loan. If the lender judges the property to be very risky he may also charge a very high rate of interest to compensate for the added risk,  or simply refuse a loan.

In addition to the evaluation of operating income, the commercial lender usually follows a guideline which limits the amount of the loan to a percentage of its appraised value. The particular percentage applicable to a property varies according to a property’s use, location, age, degree of specialization and other factors which contribute to its saleability. Highly specialized improvements indicate greater difficulty in reselling or re-leasing, and are therefore subject to lower loan-to-value (LTV) limitations.

In either case, the lender will lend the lower amount as determined by the DCR and by the LTV.

Some commercial lenders are willing to accept the property as total security for the loan. In the event of a default by the borrower the lender would acquire title to the property, but would not have any recourse against the borrower for any monetary deficiencies suffered by the lender upon resale of the property. Other lenders, however, will look secondarily to the borrower to cure any deficiencies. These loans are known as recourse loans .

Most commercial loans are structured to completely amortize over a period of from 15 to 30 years, with 20 or 25 years being most common. Nevertheless the great majority of loans become all due and payable at the end of the 10th year. Shorter due dates are common and are usually offered at slightly lower interest rates.