By Venture Mortgage Corporation
See the first article in this series entitled, "The Foundations of Commercial Real Estate Financing".
Now that we’ve gone over the basics of commercial real estate financing, it’s time to discuss how a lender comes to agree to mortgage your commercial property.
In this article, we’ll discuss the lender’s point of view on a multifamily loan and find out what they are looking for when considering the investment.
Lenders need details, so you should be prepared with as many records as possible to allow for a full understanding of the lending situation. For this property type, lenders look at several components when deciding whether a property is a good investment and if the loan is likely to be repaid as agreed:
1) Current and Historical Cash Flow: Lenders want to know that the property will generate sufficient cash to make the monthly debt service (mortgage) payments. In the case of the multifamily property, lenders will analyze the current rent roll (a consolidated report showing the names of tenants, rent amounts, and lease termination dates) and expenses to determine net operating income. Net operating income, or NOI, is defined as income minus expenses before mortgage payments. Lenders use a ratio known as the debt service coverage ratio (DSCR) to ensure that cash flow is sufficient to cover the mortgage payments with some additional cushion, and they generally like it to be >1.20. DSCR is the NOI divided by the annual mortgage payment, and a positive DSCR reflects a property with a positive cash flow.
2) Borrower’s Financial Situation: A lender will need to feel confident that the borrower, borrowers, or borrowing entity is in good financial standing. This generally means having liquid capital (read:cash in the bank) available for at least 20% down toward the purchase price of the property and the equivalent of 6-9 months’ mortgage payments worth of capital reserves. Additionally, lenders will often look at a borrower’s personal credit score: anything under 680 will raise questions about repayment willingness and ability. Any past adverse credit action (foreclosures, short sales, liens, judgements, and collection accounts) will need to be documented, explained, and corrected to the lender’s satisfaction.
3) Condition of the Property: The lender will want to look at the property and the surrounding area. Is the area rapidly decreasing in population or in an economic decline? Does the population support an acceptable (low) vacancy rate? Are the current rents reasonable and sustainable? Are the amenities of the property available in line with other comparable properties, ensuring that it attracts occupants in the market? Is there deferred any deferred maintenance (i.e., a roof that will need to be replaced in the next six months)? An appraisal will evaluate the market value of the property considering these and other pertinent factors. Remember, lenders base loan amounts on the appraised value of the property and its ability to cover the debt service (i.e., a DSCR >1.20), not the price that the seller is asking. If the appraisal comes in far below what is expected, the lender will hold to the loan-to-value metric based on the appraised value.
This is a fairly extensive, but not exhaustive, list of lender considerations regarding multifamily properties. A lender would not be doing you, or itself, any favors by accepting mortgages on properties that are unlikely to cash flow and increase in value. Additionally, a poor multifamily investment can spell financial ruin for a new (or any) investor, especially one without sufficient capital reserves to weather an unexpected storm.