Underwriting for Commercial Real Estate Loans – How it Works
Are you about to go through underwriting for the first time? Chances are you do not know much about this process or how it works. You must understand how underwriting for commercial mortgage loans works to increase your likelihood of approval.
Here, you will learn everything about commercial loan underwriting.
A Description
Loan underwriting means ascertaining the risks of lending money to someone based on property value, credit history, income ratios, and debt analysis. Underwriting determines whether someone’s application will be approved or denied.
At times, lenders set specific requirements that every applicant must meet to qualify. A few examples of these requirements include income, minimum credit scores, and debt-to-income ratios. Furthermore, the underwriting process uncovers how much money one can borrow based on cash flow, loan-to-value ratio, and debt service coverage.
Documents to Provide
Gathering and organizing the papers needed for the underwriting process may seem challenging. However, things will become easier with a clear list to help ensure that you have what you need for a successful process. Lenders may have their own exclusive requirements regarding the documents needed, but here are some of the documents you will likely require during underwriting for commercial mortgage loans.
- Official income statements like 1099s and W-2s from the previous two years
- Pay stubs from the last 30 days
- Official government identification card and social security number
- Federal tax returns from at least the previous two years
- Recent bank statements and other account statements showcasing assets
- Information related to other long-term debts, such as auto loans, additional real estate loans, credit cards, student loans, etc.
The Steps
Underwriting for commercial real estate loans is complex, with eight different steps.
1. Credit Report
This is the first thing a lender will check. They will want to see a FICO score above 680 but will favor people with a higher score for obvious reasons. In an ideal world, you would have a score above 700. They will analyze your credit report in search of late payments, defaults, collections, etc.
2. Debt-to-Income Ratio
Another factor a lender will consider is the client’s debt-to-income ratio or DTI. This is a calculation of all debts compared to the applicant’s income. It includes debts like credit card debt, mortgages, student loan debt, auto loans, and more. Generally speaking, you need a very low DTI ratio.
3. Net Worth
Net worth is considered during the underwriting process for commercial properties but not for residential real estate. Lenders scrutinize net worth because income is not everything. Instead, a few lenders focus on assets owned by a loan applicant to determine their net worth. They do this by adding up the value of all their assets before subtracting the value of debts.
4. Cash Flow
This is yet another crucial factor in the process of commercial real estate loan underwriting. Lenders want to make sure you have enough cash consistently to be able to afford monthly mortgage payments. If you have no money coming in, chances are that you may struggle to pay them back.
5. Net Operating Income
One aspect considered by lenders to determine cash flow is the net operating income or NOI. This formula involves subtracting the operating expenses from the property revenue to get an idea of how much revenue a property can generate. You may need to submit documents, such as a rent roll or proforma, to complete this calculation accurately.
6. Loan-to-Value Ratio
After the previous section, the lender will calculate the loan-to-value ratio or LTV. This calculation uses the actual value of the property and not the purchase price. An appraisal will be conducted by a certified appraiser to determine the actual value. Lenders create and follow their own guidelines for LTV ratios that they will accept during underwriting.
7. Debt Service Coverage
The next step incorporates calculating the debt service coverage ratio, or DSCR. This calculation ascertains whether the property will be able to generate enough cash flow to cover the monthly loan payments. It involves previously calculated NOI and dividing the same by the annual debt service or the total amount due in one year.
8. Maximum Loan Analysis
The last step in the underwriting process takes all the information and calculations made so far to determine the maximum loan amount the borrower qualifies for. The lender determines the maximum loan amount by taking the lesser of the two amounts calculated by the LTV and the DSCR.
Also Read: Can a Felon get an FHA Loan? All You Need to Know
Wrapping it Up
The underwriting process of commercial mortgage loans can be intimidating and nerve-wracking. If you are approved, your dreams will come true. Conversely, denial will crush your ambitions. While there is no absolute fool-proof way of guaranteeing approval, you can do a few things to simplify the process and increase your chances.
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