Underwriting Guidelines

Commercial Financing is underwritten on a case by case basis. Every loan application is unique and evaluated on its own merits, but there are a few common criteria lenders look for in commercial loan packages.

Financial Anaylsis

A key component in making an underwriting evaluation is the debt coverage ratio. 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 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.

Loan to Value

Unlike residential lending, commercial investment properties are viewed more conservatively. Most lenders will require a minimum of 20% of the purchase price to be paid by the buyer. The remaining 80% can be in the form of a mortgage provided by either bank or mortgage company. Some commercial mortgage lendeers will require more than 20% 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 mortgage lender will use the lower of the two numbers to determine the loan that will be made.

Credit Worthiness

For 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.

Property Analysis

Fair 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.

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Commercial Lending Ratios

Most of real estate lending can be boiled down to the results of three ratios:

                     . Loan-To-Value Ratio
                     . Debt Ratio
                     . Debt Service Coverage Ratio (DSCR)

The bulk of the energy spent "processing" a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the above 3 ratios.

The Loan-To-Value Ratio (LTVR) is defined as follows:
Loan-To-Value= Total loan balances (1st mtg+2nd mtg+3rd mtg) / Fair market value (as determined by appraisal)

Loan-To-Value Ratios seldom exceed 80% because the lender always want some extra protection against default.

The second ratio that lenders use when underwriting a loan is the Debt Ratio. The Debt Ratio compares the amount of bills that the borrower must pay each month to the amount of monthly income he earns. More precisely, the Debt Ratio is defined as:
Debt Ratio = Monthly Debt Obligations / Monthly Income

Obviously someone whose Debt Ratio is 150% is in trouble. A Debt Ratio of 150% would mean that a borrower's obligations are one and a half times his income. Debt Ratios seldom are allowed to exceed 40% in practice.

The final ratio used in lending is the Debt Service Coverage Ratio (DSCR). The Debt Service Coverage Ratio is a sophisticated ratio only used for large loans on income producing properties. It is defined as:
Debt Service Coverage Ratio = Net Operating Income / Debt Service

Net Operating Income is the income from a rental property after deducting for real estate taxes, fire insurance, repairs, and all other operating expenses; and Debt Service is the mortgage payment on the property. Most lenders insist that this ratio exceed 1.0. A debt service coverage ratio of less than 1.0 would mean that the property did not produce enough net rental income for the owner to make the mortgage payments without supplementing the property from his personal budget.

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Commercial LTV Ratio

The 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

First let's look at the numerator. If the borrower is only applying for a first mortgage, and there will be no other loans on the property, then the beginning balance of the new loan requested should be inserted in the numerator.

However, if the borrower is applying for a second mortgage, then the "underwriter" (the person who determines whether or not the loan qualifies) should insert the sum of the first and second mortgages in the numerator. Similarly, if the borrower is applying for a third mortgage, then the underwriter should insert the sum of the first, second and third mortgages into the numerator.

When the borrower is applying for a second or third mortgage, the loan-to-value ratio is often known as the combined loan-to-value ratio (CLTV ratio).

Now let's look at the denominator. Generally the fair market value of a property is determined by an appraisal. There is one important exception, however. When the proceeds of a mortgage loan are used to buy the same property that is securing the loan, then that mortgage is known as a "purchase money loan." If the appraisal comes in lower than the purchase price in a "purchase money" transaction, then the lender will use the LOWER of the purchase price or appraisal.

Mortgage brokers are often asked by real estate agents and buyers to base their loan on the appraised value rather than the purchase price. Their claim is that they have negotiated a super deal and that the property is worth much more than what they are paying for it. This may be so (although generally untrue), but lenders always base their maximum loan on the lower of purchase price or appraisal. The lender's argument (its their money, so there is really very little argument) is that an appraisal is really no more than an estimate of fair market value, no matter how competent or conscientious the appraiser may be. The only true indicator of value is the marketplace in which "a willing buyer and a willing seller, each in full knowledge of the salient facts, and neither under undue pressure, agree upon terms." If the property sells for "X," then it is probably only worth "X."

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Appraisal To Establish Home Market Price
In the real world, very few individuals order appraisal reports to establish an offering price or to substantiate a purchase price. At the point that an offer to purchase (in a typical residential transaction) is made, the price has been set by other parties, not the purchaser. The price has been determined by the seller, who wishes to obtain the highest price possible, or the agent, who receives a percentage of the price as compensation and often represents the seller in the transaction.

The real estate agent will typically perform a comparative market analysis (CMA). The appraisal laws in most states allow real estate agents to perform CMAs without an appraiser's license or certification. A CMA is a necessary part of the agent's preparation for a listing and consists of examining sales of properties in the area to arrive at a listing price. The reliability of the CMA depends upon the agent's experience and the characteristics of the property. The agent will suggest a selling price to the seller based upon the analysis. However, neither the seller nor the agent are bound by the results of the analysis, and the agent is not required to follow any formal procedure in completing the CMA. If a seller wishes to list the property at a price higher than the price suggested by the agent, then the agent may be forced to accept the listing at that price or risk losing a commission.

Purchasers believe that they are getting a good deal if they make an offer lower than the listed price. But how far above the market value was the property listed? 10%, 15%, maybe even 20% above the fair market value? A negotiated price of 10% less than the listed price on a property that was listed at 20% above its value is not a bargain. The agent cannot tell the purchaser that the offered price is higher than the value, or even higher than their own CMA. In most states, they must submit the offer to the seller.

The seller of a property may want to order an appraisal before listing the property. Of course, the cost of the appraisal is always a deterrent, especially if the seller knows that a buyer will pay for it when applying for a loan. But the appraisal is often justified. The seller could lose a sale if the property appraised for less than the sale price when appraised by the appraiser.

Commercial Debt Ratios

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:

                          1. Top Debt Ratio
                          2. Bottom Debt Ratio

The "top" debt ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income

By "monthly housing expense" we mean either the borrower's monthly rent payments, or if she owns her own home, the total of the following -
Monthly Housing Expense

     . 1st mortgage payment on home plus
     . Real estate taxes (annual cost/12) plus
     . Fire insurance (annual cost/12) plus
     . Homeowner's association dues(if home is a condo or townhouse) plus
     . Second mortgage payment (if any) plus
     . Third mortgage payment (if any).

You will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While P.I.T.I. is not exactly the same as Monthly Housing Expense because it does not include homeowner's association dues, the two terms are often used interchangably.

Lenders have learned over the years that a borrower's "top" debt ratio should not exceed 25%. In other words, a person's housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.

The second ratio that lenders use to determine if a borrower can afford her obligations is the "bottom" debt ratio. It is defined as follows:
Bottom Debt Ratio = (Total Housing Expense + Debt Payments)/Gross Monthly Income

The only difference between the two ratios is the inclusion in the numerator of "debt payments." Debt payments include the following:
Debt Payments

  . Car payments
  . Charge card payments
  . Payments on installment loans, for example - a payment on a washer &      dryer that the borrower purchased.
  . Payments on personal loans, for example - a signature loan from the      borrower's bank.

What is not included in "debt payments" is Utilities such as PG&E, water or telephone and payments on real estate loans. Real estate loans are usually offset first by the net rental income from the property. If the borrower has a net positive cash flow from all his rentals, then the net income is usually added to his "gross monthly income." If the borrower has a net negative cash flow from all of his rental properties, then the amount of the negative cash flow is usually added to the numerator of the "bottom" debt ratio as if it were a monthly debt obligation, like a car payment.

Traditional lending theory maintains that a borrower's "bottom" debt ratio should not exceed 33 1/3%. In other words, the total of the borrower's housing expense and debt obligations should not exceed 1/3 of his income. Lenders often will stretch on this ratio to as high as 36%, and some have even been known to stretch as high as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky loan than a loan with a debt ratio of 32%.

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Commercial Loan Checklist

The following list will help you identify the types of information a banker will need to make an informed decision about your business.

      . Three years income tax and financial statements
      . Year-To-Date Profit & Loss and Balance Statement
      . Personal Finance Statements
      . Projected Cash Flow Statements for next 12 Months
      . Pro Forma for next 12 Months/Length of Loan
      . Federal and State Taxes Information
      . Collateral Sheet
      . Well Written Business Plan

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Commercial Financing Options

Credit Lines

Under a credit line agreement, the lender supplies a business with funds intended to fill temporary shortages in cash that are brought about by timing differences between outlays and collections. Typically used to finance inventories, receivables, project or contract related work.

Short-Term Loans

Used for seasonal build-ups of inventory and receivables. Generally repaid in a lump sum at maturity, made on a secured basis and are for a term of a year of less.

Asset Based Loans

Lender advances funds based on a percentage of your current assets. The loan is used as source of funds for working capital needs. Lender typically takes a security position in the assets owned by the business.

Contract Financing

Funds are advanced to you as work is performed. Payments by the contracting party are generally made directly to the lender.

Factoring

Factors actually buy your receivables and rely on their own credit and collection expertise. Essentially, your customers become their customers. Factoring is used by firms who are unable to obtain bank financing. The cost of financing is usually higher than other forms of S-T financing.

Term Loans

Used to finance your permanent working capital, new equipment, buildings, expansion, refinancing, and acquisitions. Commercial banks are the major source of funding. The term of the loan is based on the useful life of the assets being financed or collateralized. Your projected profitability and cash flow are two key factors lenders consider when making term loans.

Equipment and Real Estate Loans

Loans are fully secured by the equipment being purchased. Typically banks loan 60-80% of the value of the equipment and is repaid over the life of the equipment.

Lenders make long term loans secured by commercial and industrial real estate. The loan is usually made up to 75% of the value of the real estate to be financed. Repayment terms range from 10 to 20 years. Lenders also make second mortgages on real estate. The amount of the second mortgage is based on the appraised market value and the amount of the first mortgage.

Leasing

Can be accomplished through a bank, leasing or finance company. Your business will be subject to the same type of review as when seeking a loan, specifically cash flow of company, value of lease object and useful life. Lease terms range from 3 to 5 years. At the end of the lease, there are generally 3 options: purchase, renew and return.

3-15 YR Balloon loans

Balloon loans offer interest rates that are fixed for a period of years. Typically these loans are pegged to a treasury index. Terms are for 3, 5,7,10 or 15 years. The amortization schedules are generally for 20 or 25 years.

When a balloon loan matures at the end of the agreed term, the remaining principle balance outstanding is due at that time. The borrower can pay off the loan by either selling the property or refinancing. Investment property is typically owned for a previously defined period of time. Analyze your investment strategy before securing a balloon. Having to redo a loan is expensive.

Adjustable rate loans

An Adjustable rate loan will typically fully amortize with no balloon features. These loans may or may not have adjustment caps. The rate is determined by an index plus a margin. The indices used are generally U.S. treasury bond rates. Rates are adjusted at a certain point in time using either the current rate of the index in question or the average of the index for the prior year. In either event, the index used will correspond to the adjustment term. If the loan is a three year adjustable, then the index used should be the three year treasury index.

Some adjustable rate loans are fixed for an initial period of years and then will adjust after that period. For example a 5/1 adjustable is fixed for the first five years and there after will adjust each year. The index used will be the one year treasury rate.

Please note that commercial lending is not standardized as it relates to programs and to guidelines. Banks must meet certain federal standards, but the index, margin, amortization, term and fees are components that are controlled by the investor based on their risk profit analysis. Remember that this mortgage will be the greatest expense your investment property will be responsible for.

As such we recommend that you consult your real estate agent and your loan officer to assist in providing