CLIENT EDUCATION Commercial Loan Qualification
Borrowers should be prepared to furnish detail and documentation on both the purchasing or vesting entity along with basic information on the key principal individuals involved in the transaction. Commercial lenders are mostly focused on the collateral property for qualification, but borrowers are still reviewed and expected to meet their minimum requirements. Strong borrowers (financially, experienced, etc.) can also help improve qualification for the most competitive programs so a review of this is important to securing best available financing.
Recourse vs. Non-Recourse
This term refers to the borrower(s) signing personal guarantees for the commercial loan. A recourse loan requires personal guarantee, while a non-recourse loan does not. However, even non-recourse loans require some level of guarantee for “bad boy” carve-outs which typically refer to criminal or fraudulent activity by the borrower causing default. A lender will determine who (or how many) guarantor(s) will be required based on the buyer profile and qualification, but typically is required of any manager (if the borrower is an entity such as an LLC) and also any person that will have 20% or more ownership. Non-recourse loans typically will anchor more on the property instead of the borrower for security or require a high equity position compared to the debt proposed. A recourse loan with qualified signers can make a loan request more attractive to a lender when dealing with more difficult properties.
The personal financials of the borrowers (typically any person owning 20% or more of the purchasing entity along with all Managers) will be collected and reviewed by the lender. Lenders want to evaluate whether the individuals signing for the loan have the financial strength and wherewithal to make their mortgage payment or balloon payment should the property run into issues and no longer operate at a net income that can cover the mortgage payment. Lenders will want to see the entire picture, but the primary factors that are analyzed are liquidity, net worth, and annual income. These are considerations that show a borrower has access to other sources of capital and lower the risk of default on the loan.
A client should expect to furnish bank statements, tax returns, and complete a verified personal balance sheet. While every lender has their own policies and requirements, there are a few general guidelines in the industry: a net worth equal to or larger than the loan request, M1 liquidity to cover at minimum 12 months’ worth of principal and interest payments, and a global cash flow of 1.20x or higher. Your personal balance sheet will be pre-screened during the loan origination process and verified during underwriting. It is important to have HarborWest fully review your balance sheet prior to accepting a loan to hedge against any underwriting issues, especially since each lender will have their own guidelines and requirements.
Business financials are especially important on owner-user commercial real estate transactions such as an SBA loan. If the client is a business owner operating his company from the subject property, the ability to repay is dependent on the profitability and success of that company, and not on the cash flow of third-party tenants since they do not exist. Additionally, if there is only a single recourse guarantor on an investment property loan and that individual’s annual income is highly or solely dependent on their owned business, those financials will also usually be evaluated.
A client should expect to provide historical business tax returns (usually the preceding 3 years and preferably CPA audited), interim financials since last tax return filing, and current business financials (i.e. income statement, balance sheet, accounts receivable/payable, debt schedule, etc.). Lenders will analyze your business financials first for ability to pay the proposed mortgage based both on current and historical operation. They will also review for positive and negative trends in the income/expense categories, growth and scale, and any potential financial issues that would impact the borrower’s ability to repay. A few common examples would be a single customer being responsible for the majority of the company’s sales and income, or an equipment loan interest expense that is in a discount period but will significantly increase next year for the company.
This is usually only a consideration for owner-user transactions where the loan qualification is based solely on the borrower’s business. Financials as described above are the primary determinant, but other considerations are also considered. A lender is not (and usually cannot) be an expert on a client’s business or know their industry as well as the client, but a very high-level assessment will likely be taken to see if the lender wants to move forward. For example, a company offering outdated retail services to consumers, or a business that is anticipated to be negatively impacted by pending state regulations, might not be attractive to some lenders. In addition, if the borrower owns a company that is the sole source of income for that person, a lender might give a second thought to this before making a loan offer or defining their loan conditions.
Credit & Character
Loan qualification comes down to the lender wanting to determine to the best of their ability how likely you are to default on your new mortgage payment. While they can’t predict what will happen in the future, they surely can evaluate how you’ve done in the past. Credit reports and background checks help accomplish this best. Commercial lenders like any other creditor want to see a history of solid repayment and a clean record. Past credit issues are not a deal killer per say, but any past instances do need to be addressed early on and might make a client ineligible for certain programs. Lenders will also want to see a clean background check for criminal record, court records and lawsuits, and many times will do a general online search of the borrower and affiliates for anything online that might be concerning or curious.
This qualification category in our opinion has the grayest area - credit and character issues are many times explainable or solvable. It’s importance also differs from lender to lender, and even from decision maker to decision maker within that lending institution. Having a strong grasp for lender flexibility with these hurdles is important to securing quality financing, as many lenders take advantage of credit impacted investors and corner them into loan programs they may not necessarily deserve. HarborWest uses our experience and relationships to solve credit and character hurdles during application to ensure you have a fair opportunity at the market’s best available programs.
With investment property financing, experience is a key factor for a lender although also another subjective factor similar to credit and character described above. In general, lenders want to see owners and investors with experience to successfully operate the subject property. That may be experience with a certain commercial sub-type, or experience in a certain market or situation stage. A longer history of experience, larger portfolio of similar properties or stronger resume of professional experience supporting the investor’s case of being able to own and manage the property without the lender being concerned – the better the lender will feel, and the more aggressive they can get on loan terms. They may also evaluate your property manager if you have professional management in-place.
Many times, this can be a subjective assessment and decision and an area where the borrower and lender disagree. Lack of experience can be a deal killer many a time or can impose unwanted conditions such as requiring third-party professional management (decreasing NOI to the client) or switching management companies which can be a hassle if it cannot be waived by your mortgage broker. You will want to address this potential hurdle upfront before accepting any loan offer. Hurdles with this requirement can usually be mitigated by higher equity, professional property management requirement, or a higher yield to the lender for the risk.
Commercial mortgage qualification is primarily based on the asset. This is probably the largest difference between residential and commercial lending: most of the scrutiny is focused on the property instead of the borrower. At the end of the day these are investment properties and need to stand on their own, especially if the loan is “non-recourse” without personal guarantee of the owner(s). Many times, a commercial mortgage is not held on the portfolio for the lender but instead sold to a different institution on the secondary market or participated by other lenders in order to further divide the risk or free up funds for smaller lenders to lend to other customers. Qualification for commercial financing is in a nutshell a determination of risk for the lender, and what loan terms make them feel comfortable with that risk. If the lender is not confident in the property’s future performance, they will adjust their underwriting or offered terms that do make them feel comfortable.
The asset type (multifamily, office, retail, etc.) is the first factor a lender will evaluate when looking at a new commercial loan request. Many lenders specialize in one property type(s) or another as each have their own nuances or favorability. They may also have a limited allocation for the year to lend on certain subtypes, so depending on how full each “bucket” might be a lender will have preferences and more attractive terms for different subtypes throughout the year. Economic and market factors can also affect the desirability for certain product types. A great example recently would be the shift to e-commerce business vs. brick and mortar, or COVID-19 -- both have put a black mark on most retail and hospitality properties which have not been open or performing, and also have put tremendous scrutiny on multifamily property rental collections in states with tenant friendly eviction laws.
Property types like multifamily are more common and always a desirable asset class for most lenders. Other asset types like special purpose (churches, event centers, museums, etc.) can be very specialized to only a few select lenders that understand these industries and have available programs.
Location, location, location. You hear it all the time. And just as it rings true to an investor, so too does it for a lender who shares ownership with you. Lenders mostly want to see properties that are in major metropolitan markets as opposed to rural areas, in areas of high traffic count and visibility, and ideally in an area with less competition or potential for future competition. Environmental concerns also factor into this if the property is neighboring to heavy industrial use or properties with tenants such as laundromats or gas stations as these can have environmental damage that trickle over to the subject property.
Location may also be important internally to the lender, depending on again their portfolio allocation, or desire to stick to markets that they know best or specialize in. If the lender is a bank, they might also have lending “footprints” where they can only finance deals if the property or borrower falls within an acceptable distance from a bank branch. A full market and location analysis will typically be performed by the Appraiser, who will provide very insightful data on the demographics, traffic count and competitive properties in the area to the Lender. While this data is considered, it is usually the lender’s experience with similar properties in their portfolio and personal familiarity with the market area that moves the needle the most. HarborWest tracks and maintains relationships with lenders that specialize in certain markets in order to provide the most competitive financing quotes to our clients.
Quality & Condition
This hurdle is usually evaluated by the inspectors that complete the on-site inspections of the property on behalf of the lender and delivers their report(s) to them for review. Many times, this is solely an appraisal, but depending on the property type/features and lender requirements, may also include an environmental report, building inspection, earthquake seismic analysis or a visit from the lender themselves. Besides the environmental concerns explained above in Property Location, the physical condition of the property can be a concern for a lender. Any health and safety issues need to be cured prior to loan funding, which may include mold in-units, deteriorating staircase steps, major roof damage, or lack or adherence to state or city building code.
The second consideration is any “deferred maintenance” which can be a subjective and negotiated item with the lender. Lenders commonly will hold back or reserve the cost for any noted deferred maintenance until cured, which can be an issue if the investor is counting on a specific predetermined loan amount offer. Common examples of this would be parking lot asphalt repairs, stucco or window repairs, and A/C unit replacements.
Besides hard line requirements, there is also simply a “curb appeal” aspect to this. Although a property’s curb appeal or attractiveness per say may not directly correlate to its condition or performance, there is still a subjective aspect to a credit decision and decision makers would prefer to have an attractive property. One instance where this isn’t usually a factor is when the property is appropriate for a bridge loan or rescue loan. It is understood by these lenders that the quality or condition of the property may be a selling point for the investor whose strategy is rehab and repositioning of the asset.
The property appraisal is a very important factor in determining the final loan terms from the lender. A property appraisal will be completed by an accredited appraiser that specializes in the specific commercial subtype and usually in the same market as the subject property. The property appraisal will give the lender important information to consider including likely market value, rental rates and trends, market competition and demographics, physical assessment, and a boots on the ground inspection of tenant operations, property condition, and property management.
The appraised value many times does not agree with the owner’s estimated value or the purchase price if the financing is for an acquisition. Since an appraisal is really an educated opinion by the appraiser, an investor does not need to agree with their assessment. Perhaps the appraised value comes in lower than expected based on the appraiser’s opinion, but the investor has a different opinion and is still confident to move forward on the purchase. However, for a lender, the appraiser’s assessment always takes precedence over the investor’s opinion. Lenders will usually consider the property value to be the lower of the purchase price or appraised value. Where this becomes an issue is when evaluating the maximum loan-to-value (LTV).
For example, let’s say a multifamily property is under contract for $8,000,000 but the appraisal comes in at $7,200,000. Let’s also assume the lender has a maximum 70% LTV condition on their loan offer. Pre-appraisal the loan amount expectation was $5,600,000, and post-appraisal that loan amount would be adjusted down to $5,040,000. That lower appraisal resulted in the investor needing to bring in an additional $560,000 to close escrow -- which many times the investor may not have. To avoid this potential issue (and potential loss of investment or escrow deposits), HarborWest can help pre-determine the appraisal value using their contacts and resources and prepare standby backup options to hedge this scenario. This might include bridge loan options, a standby lender that can finance a second trust deed, or a competing option with a higher maximum LTV that is able to assume the property reports from the failed lender.
NOI & Cash Flow Ratios
Cash flow is arguably the most important factor for a lender when evaluating a commercial loan request. There are many uncontrollables to a lender once a lender funds the loan. Management could fall apart, tenants could go bankrupt and vacate their leased space, borrowers could suffer financial hardships, the property could be impacted by damage from a storm – and numerous other possibilities, all leading to the borrower’s ability to repay the mortgage being afflicted. A lender can impose loan conditions to help mitigate some of these risks to a degree, but at the end of the day the responsibility lies with the borrower and the market.
So, having security and comfort in the property’s historical, current and pro-forma cash flow ratios can create huge leverage for an investor. The better the property can predictably cash flow, the more “buffer room” there is for things to go wrong. The NOI (net operating income) is the primary number all ratios are based and can be calculated differently depending on the lender and their underwriting. Meaning one lender to another likely will not have the same NOI even though they both evaluate the same property financials. Most commonly, lenders will use a DSCR (debt service coverage ratio), LTV (loan-to-value ratio) and DY (debt yield) ratio calculations to determine the cash flow strength of the loan request. These concepts are explained in a different section of this guide.
In general, a higher DSCR and DY ratio and a lower LTV ratio will make a loan request more attractive. Lenders will have their program minimum requirements but may be able to make exceptions for a deal they want or for brokerages like HarborWest that they work closely with on other loan opportunities.
The value of a commercial property is determined based on the income of that asset. A key concept to understand for an investor is that when you purchase a commercial investment property, you are not buying a building – you are buying the cash flow which is secured by the leases and collateralized by the building. The tenancy and cash flow created from those leases are what create value. The leased value of an investment is most always greater than the physical collateral value. Strong tenancy creates good cash flow and low risk, which is attractive to both the investor and the lender.
An assessment of the tenant base will be conducted by the lender. They will consider the diversification of the tenants, the square foot allocation risk, the general strength or outlook for a tenant’s industry, and any potential future legal risk a tenant may pose. Lease audits will also likely be conducted to determine the rent collections presented are accurate, and that there are no major risks hidden in the lease that could affect the current contract as understood. Other factors such as the tenant’s tenure at the property, length of the lease and potential for vacancy are also considered. If the tenant, both core commercial or multifamily, has a government subsidy partner such as a city housing assistance program or are government grant sponsored, those contracts and risk of non-payment will also be considered. Should the property be a single tenant leased investment (for example, a NNN leased Starbucks), scrutiny on that tenant will be crucial as the entire property income relies on that tenant’s lease. Single-tenant (NNN) considerations are explained in a different section of this eBook, but in general lenders will want to analyze the tenant’s lease, financials, and credit in determining how comfortable they are with them.
Conversely, an asset class like multifamily that may have hundreds of tenants/units, will be highly diversified and not easily affected by a vacancy. Typically for multifamily, historical occupancy can help shed light on a property’s operations, management, and competition in the market. Local laws that would affect an entire tenant base are also considered, such as rent control measures and eviction moratorium laws (such as during COVID-19).
The performance of the property and strength of the borrower to make their mortgage payments are determined by the above factors. Verifying all potential legal issues however are equally as important in order to allow the property to operate freely without any legal hurdles. These potential issues can affect rent collection, value and equity, and legal responsibility by the lender which can be costly. While much is unpredictable and uncontrollable, lenders will want to evaluate they feel as comfortable as they can with the following: equitable and rightful title to the property, coverage of insurance claim risk, conformation with all legal requirements including city building codes and tenant rights, a “clean slate” confirming no current legal claims to property or borrower(s), waiver of environmental risk, and a comprehensive review and completion of documents completed by both the tenant (leases, estoppels, SNDAs) and borrower (loan documents, promissory note, guaranty, legal waivers, etc.).
These considerations are usually requirements on all commercial mortgages as a condition to approval and are essentially non-negotiable items, while the other qualification factors discussed above are used to assess the risk of the deal and determine the lender’s final loan offer.