TMG Capital West
Commercial Underwriting Guidelines
|7 C's of Commercial Credit | Financial Analysis | Analyzing Debt Service Coverage Ratio (DSCR) | Loan to Value | Credit Worthiness | Property Analysis | Commercial Loans Debt Ratios|
7 C's of Commercial CreditCommercial loan lenders are in business to make money. Consequently, when a commercial loan lender lends money it wants to ensure that it will be paid back. Traditionally, many professionals believe that the commercial loan lender considers 6 "C's" of credit each time it makes a loan, however, we feel that prudent analysis requires the any lender in today's lending environment to consider the 7 "C's" of commercial credit.
CapacityCapacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships - personal and commercial - is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
CapitalCapital is the money you personally have invested in the business and is an indication of how much you will lose should the business fail. Prospective lenders and investors will expect you to contribute your own assets and to undertake personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business you are more likely to do everything in your power to make the business successful.
CollateralCollateral or guarantees are additional forms of security you can provide the lender. If the business cannot repay its loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts receivable, and in some cases, inventory, are considered possible sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that - someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.
ConditionsConditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
CharacterCharacter is the personal impression you make on the potential lender or investor. The lender decides subjectively whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience of your employees will also be considered.
CoverageCoverage is the reduction of risk from obtaining third party protections like insurance.. Lenders are willing to take risks by giving interest rates and loan terms that they are comfortable and conform to their lending guidelines. However, when possible, they always seek to shed some risk by requiring the borrower to obtain "coverage policies" from insurance companies with acceptable coverage.
CashflowCashflow is the measurement of income (actual cash) generated by a business over cash outlays such as operating expenses, debt service costs, etc in a certain period of time. The lender wants to know how the business is managing it's cashflow and if the company is generating enough cash to support its operations. Cashflow is obviously a gauge at the financial health and potential cash accumulation of a business.
AnalysisA key component in making an underwriting evaluation is the debt coverage ratio (DCR). 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 is 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.
Analyzing Debt Service Coverage Ratio (DSCR)The most important ratio to understand when making income property loans is the debt service coverage ratio. It equals Net Operating Income (NOI) divided by 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 Rent =$200,000
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:
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 break even 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.
ValueThe 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
Unlike residential lending, commercial investment properties are viewed more conservatively. Most lenders will require a minimum of 25% (sometimes 20%) of the purchase price to be paid by the buyer. The remaining 75% can be in the form of a mortgage provided by either a bank or mortgage company. Some commercial mortgage lenders will require more than 25% 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.
WorthinessFor 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.
AnalysisFair 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.
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:
Our competitive home loan programs and rates put us at the forefront of top residential mortgage companies.
Learn about our commercial real estate loan programs and why we are one of the nations preferred commercial finance companies.
Through our extensive capital network and funding capabilities, our private lending group leads the way in specialty and niche lending.