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Sofia Capital Ventures Commercial Lending Experts Tell All

The Inner Workings of Multifamily Mortgage Underwriting Revealed

mortgage-underwriting What do Lenders look for? What makes a property qualify?

When it comes to multifamily lending, there are probably as many different kinds of loan programs and lenders out there as there are flavors of ice cream.  So how does a borrower know what kind of loan to use when purchasing a multifamily property; and when it comes time to refinance, what are the options? How do I choose?

By understanding how lenders evaluate loans, you will have a better understanding of what type of loan fits your property. There is one simple rule: Lenders hate risk!  The “riskier” the proposed loan looks, the more it’s going to cost the borrower. A “high risk” loan may not be eligible for certain lender programs, like Fannie Mae or Freddie Mac. However, it may fit at the low end of a bridge lender’s risk tolerance. The key factors that make lenders “nervous” i)high loan to value; ii) limited cash flow; iii) low occupancy; iii)poor local market conditions; and iv) lack of sponsor support.

Commercial Mortgage Basics

Now for the basics: first the property qualifies; then the borrower qualifies.  End of story.

The property qualifies on its attributes. These include location, physical condition and financial performance. Some of these are under the borrower’s control. Some are not. The lender then looks to the strength of the borrower to shore up any deficiencies by providing additional assets and/or liquidity. All of this is done to minimize the lender’s risk or exposure to the downside.

Now, let’s break it down even further. The discussion below covers the main factors that a lender looks at to determine where a loan fits in their portfolio of loans, or whether it qualifies for Agency Financing (Fannie Mae, Freddie Mac, etc.) or CMBS (Commercial Mortgage Backed Securities)

Loan Quality Attributes

Two core multifamily underwriting parameters include the debt service coverage ratio (DSCR) and the loan-to-value (LTV) ratio:

  • DSCR is the ratio of annual net operating income (NOI) divided by the required annual debt service for the property. NOI is calculated as cash rental and recurring income minus normal and recurring cash operating expenses. Judgment may be required to determine NOI, and it may be defined in loan and security agreements supporting individual transactions. It provides an indication of a multifamily borrower’s ability to service its mortgage obligation using the secured property’s cash flow. The DSCR should be at a level that not only meets the required debt related payments, but includes a cushion for other associated expenses, such as providing for capital replacement reserves. The higher the DSCR, the more likely a multifamily borrower will be able to continue servicing its mortgage obligation.
  • LTV is the ratio of the unpaid principal amount of a mortgage loan to the value of the property that serves as collateral for the loan. Loans with high LTV ratios generally tend to have a higher risk of default than loans with low LTVs.

The standards for multifamily loans specify a maximum LTV ratio (usually 80%) and minimum DSCR (can be as low as 1.1). These will vary based upon the loan characteristics, such as loan type (new acquisition or refinance), loan term (typically 5, 7, or 10 years), and loan features (interest only or fully-amortized; fixed rate or variable rate). Typically, a borrower must fund the equity from its own sources to meet the LTV requirement.

Borrower Strength/Default Analysis

The borrower in a multifamily loan transaction is the legal entity that is created and backed by the real estate, including improvements to the land, and the building(s) in place. The borrower is typically a Single Purpose Entity (SPE) that is a for-profit corporation, limited partnership, or limited liability company.

Multifamily loans are generally non-recourse to the principals or sponsors of the projects, but not to the borrower. While the borrowing entity is directly liable for the debt, it typically has little to no balance sheet strength other than the underlying collateral and cash flows to support the loan in the event of distress.

Sometimes the sponsor is required to support the borrowing entity from the sponsor’s portfolio of like assets that may be generating excess cash flows to service this debt. The sponsor’s reputation, property management experience, financial capacity, and other real estate holdings are also analyzed in detail.

A quick rule of thumb (which varies widely) is a combined new worth (borrower + sponsors) equal to the loan amount and 6-12 months reserves to cover principal and interest (PI).

Property Quality

The quality of multifamily properties is a driving factor in assessing credit risk. Since the property is the source of repayment and collateral for a multifamily loan, the property should be in good condition. The Lender will also require independent assessment of property condition and environmental condition.

Property Appraisal and Environmental Assessment

All Lenders require third-party assessments and appraisals to support the underwriting decision. The purpose of an appraisal is to estimate the current and perhaps future market value of the property. The environmental assessment (usually a Phase I report) protects the lender from any potential liabilities. The Lender requires the appraiser and assessor to be independent to avoid any conflict of interest. Therefore appraisals ordered by the borrower are seldom accepted.

Market and Submarket Factors

As part of evaluating the property and borrower capacity, the underwriter also analyzes the overall market and submarket location of the property to determine whether there are any additional risks that could impact property value or borrower’s financial capacity and ability to refinance. The underwriter may review such factors as location, vacancy rates, unemployment rates, supply and demand levels, and the availability of local services, such as health care and schools.

Other Factors

Insurance:  The borrower must provide, at a minimum, the following types of insurance: property damage, liability, professional liability, title, and various natural hazard-related insurance.

Balloon and Pre-payment features:   At underwriting, the Lender also monitors refinance risk by requiring pro forma analyses. These analyses include growth-rate projections for income and expenses and the projected DSCR, LTV, and capitalization rate at the end of the loan term. Using these analyses, the Lender will evaluate and estimate their exposure to future refinancing risk.

Congratulations if you made it all the way to the end of this article. If you are slightly overwhelmed by the sheer complexity of issues and number of details, you are not alone. Consult your Commercial Lending Expert at Sofia Capital Ventures for a no-fee Loan Evaluation. CONTACT US today.

And, if you want to know even more about Fannie Mae and Freddie Mac Underwriting Procedures, CLICK HERE.

 

By |November 11th, 2016|Commercial Lending|0 Comments
Barbara Leuin, Commercial Lending Expert
Barbara Leuin, Ph.D., Commercial Lending Expert, Carlsbad, CA, is a serial entrepreneur and real estate investor, with over 30 years of professional experience, including 13 years of university teaching in business and economics; 16 years of business consulting; and 5 years as a full-time real estate investor. Since 1996, she has helped start-up businesses access millions in private capital. As CEO, Barbara brings visionary leadership, team-building and leadership to Sofia Capital Ventures. She is responsible for lender relationships, broker training and identifying market opportunities.

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