Back in the good old days, prior to the Great Recession, getting a loan approved was a relative breeze. Underwriters focused almost exclusively on the property and did a cursory review of the borrower. They would ask such in depth questions as: “Is he breathing?” Yep. “Does he have enough money for the down payment?” Yep. Ka-ching! The loan was approved. Well it wasn’t quite that easy, but you get my drift.
Gone are the days of a quick approval of the borrower. The process at most banks has been replaced with a detailed underwriting of the borrower’s ability to pay back the loan. Underwriting criteria for approving a borrower for a loan vary from one lending institution to the next but most focus on these six credit factors:
1. Credit score – nothing has changed here. To receive the best rating from a bank the sponsor should show a credit score of 720 or better. All blemishes on their credit report, including all 30 day late payments or longer, need to be explained in writing.
2. Experience – Ideally, an applicant should have at least 10 years of experience owning and/or managing commercial real estate. The more years the better. Without experience a professional management company would be required.
3. Global cash flow – This new wrinkle in underwriting is the Darth Vader of underwriting. It is a laborious and time consuming attempt to determine how well all the sponsor’s commercial real estate holdings are doing that are shown on his/her real estate owned (REO) schedule. Total the combined net operating income (NOI) of all the borrower’s properties, and divide by the annual debt service of all his/her properties. Ideally a lender would like to see a combined debt coverage ratio (DCR) of 1.25 to 1 or greater.
For example, let’s say the combined NOI of the borrower’s commercial real estate equals $500,000 and his combined annual debt service equals $400,000. Therefore the borrower has a DCR of 1.25 to 1. Some lenders will also look at each individual property on the borrower’s REO schedule and if there is one or more properties that have a negative cash flow, i.e., the annual debt service exceeds the property’s NOI, then the borrower will have to explain why this is so and what steps are being taken to correct the situation.
4. Personal cash flow – This analysis focuses on the sponsor’s personal income and expenses. It is calculated by totaling annual income from wages, interest income, real estate investments, etc. and dividing it into all living expenses and personal debt, including mortgage payments, auto loans, credit card debt, etc. This ratio should be better than 1 to 1.
The underwriter also looks closely at the amount of revolving debt and compares it to the amount of cash (not including retirement accounts) shown on the borrower’s balance sheet. The amount of cash on the balance sheet should exceed the amount of revolving debt and the more it does the better the borrower’s rating.
5. Global liquidity – Divide the total cash shown on the borrower’s balance sheet by the proposed monthly debt service for the new loan. This will tell you the number of months of liquidity the borrower has available should something go terribly wrong resulting in the property not being able to pay the mortgage payment from the cash flow off the property. Most lenders would like to see, at a very minimum, 6 to 9 months of a liquidity cushion. So if the monthly mortgage payment is $10,000 the borrower better have $60,000 to $90,000 in cash reserves in order to qualify for the loan.
6. Global Leverage – the total commercial real estate debt divided by the total estimated value of the borrower’s real estate portfolio should not exceed 75%. The less leveraged the borrower’s real estate is, the better his or her rating.
As Paul Harvey used to say, “Now you know the rest of the story.” This is the new normal and this is why it’s taking so much longer to get a deal closed these days. A good mortgage broker knows how each lender underwrites their loans. He then chooses the lender whose lending criteria are most compatible with the client’s financial strengths. To do otherwise unnecessarily puts his client at risk of hearing those dreaded words from the lender, “I’m sorry. But we’re going to pass on your loan request.”