How Do Lenders Underwrite Commercial Real Estate?

Venture Mortgage- Edina, MN

At Venture Mortgage, we work to constantly inform and educate you about the commercial real estate financing process. Being aware of the steps lenders take when underwriting a commercial real estate investment can give you a big advantage when seeking debt, allowing you to see your property from a lender’s perspective and empowering you to take steps to present your property in the best potential light.

Of course, when utilizing the services of Venture Mortgage and allowing us to act as your personal CFO for commercial real estate finance, we take care of all of the heavy lifting for you, analyzing your property and its financials and proactively addressing any issues before selecting the best lending options for you. With that said, let’s have an overview of the preliminary process of underwriting commercial real estate.

First, lenders want to know if the investment is feasible at the high level by examining some property financials, including perhaps a rent roll (a list of current tenants, rent amounts, and length remaining on leases), a proforma (in short, a cash flow projection for a given piece of real estate), and 2 years of historical income and expenses for the property (plus year-to-date).

The lender will advise the mortgage banker of current interest rates, LTV and DSCR limitations, and other internal lending policies.  As long as everything passes muster with these guidelines, the lender will issue a term sheet, which is a form advising what the loan offering would entail as long as the further underwriting supports the initial analysis. After the loan terms are negotiated and agreed upon, the lender will begin the full underwriting process.

Tips for Making it Simple:

  • Be aware of your current debt service coverage ratio and the loan-to-value ratio for the loan amount you seek.
  • Have and keep a current rent roll as applicable, and be prepared to provide projections for the cash flow of the property.
  • Remember that the term sheet is not set in stone: your personal mortgage banker can and will negotiate on your behalf to secure the loan that meets your needs and serves your objectives.

Now, the internal underwriting begins on the lender’s side. At this point, your property financials have been reviewed, and the lender will generally construct their own underwriting analysis: note that this can result in a different NOI (net operating income, or gross income less operating expenses) than the one you’ve calculated. Differences can include the lender increasing the vacancy and credit loss factors, based on market conditions and property type. The lender-determined NOI is then used to determine two key ratios that serve to evaluate the health of the investment: the Loan to Value ratio (LTV) and the Debt Service Coverage Ratio (DSCR). Let’s take a quick look at these formulas and what they mean to the lender.

Tips for Making it Simple:

  • Be conservative when determining your own NOI, as the lender will; in this way, you can avoid large discrepancies in underwriting.
  • Feel free to reach out to your Venture Mortgage banker to advise you of current market conditions that could affect the lender’s view of your property and its financials.

The LTV is simply the relation of the total debt against the property to the value of the property. If a property is considered to have a value of $2,000,000, and the debt on the property is $1,500,000, the LTV would be 75%. Pretty straightforward, right?                                                                   

Well, what determines the value of the property? In most cases, the lender engages a third-party appraiser to provide a professional opinion of the value of the property; however, the lender is well within its rights to make further downward adjustments to the appraiser’s value. These adjustments can be based on market conditions, property type, and limitations on cap rate used for valuation (the capitalization rate, or the ratio of NOI to asset value. See here for a further discussion on cap rates, and here for info on the foundations of CRE financing.)

The DSCR is an expression of the ratio of NOI to annual debt service; at its core, it’s a means for the lender to determine that the property has sufficient cash flow to make the loan payments. The DSCR formula is relatively simple:

                                                                  

If a DSCR is calculated at 1.0, this means that they property generates just enough income to cover the debt service payments: for reasons that should be obvious, the lender would prefer to have a margin of safety by requiring a higher DSCR in case of a decline in the NOI. As the lender seeks to mitigate its risk, it will usually require a higher DSCR for property regarded as more risky or less stable in operation. (See here for further discussion of DSCR.)

Tips for Making it Simple

Finally, the lender will use the above discussed ratios and an evaluation of the sponsor(s) to make a determination of the Maximum Loan Amount. It’s important to note that the interpretation of the data and the concessions made in these calculations will vary by lender. At Venture Mortgage, we maintain close relationships with dozens of lenders for your benefit, allowing us to originate the most favorable commercial real estate financing available for you in the market today. Feel free to reach out to us for a complimentary consultation and analysis of your next commercial real estate project: we look forward to earning your business.

We invite you to see what our clients say about their experiences with Venture Mortgage.