Commercial Underwriting Guidelines
Commercial lenders and investors look at risk, and their primary concern is repayment. They generally use three factors to judge a financing request. If one of the three factors is weak, then the other two must be stronger to mitigate the increased risk.
- The value and quality of the collateral
- The ability of the business enterprise or property to repay the loan
- The financial strength and experience of the borrowers
Commercial financing is underwritten on a case by case basis. Every financing request is unique and evaluated on its own merits, but there are a few common criteria investors look for in commercial financing packages. The typical values for the criteria depend on the type of property or business.
Debt Service Coverage Ratio (DSC)
The higher the DSC, the more net operating income is available to service the debt. The minimum permissible DSC depends on the property type, the borrower's experience, and the lender's perception of risk.
DSC = Net Operating Income (NOI) / Total Debt Service
- The NOI is the income from the business or property left over after paying all the operating expenses. Operating expenses include taxes, insurance, repairs and maintenance, utilities, management, and reserves for replacement. When computing the income, lenders and investors typically require some sort of vacancy factor (5% to 10% of gross income) regardless of the actual vacancy rate. In addition, for income-producing properties, they typically require a management factor (3% to 7% of effective gross income).
- The Total Debt Service is the sum of the principal and interest payments for all loans on the property, not just the first mortgage.
Loan-to-Value Ratio (LTV)
Commercial investment properties are viewed more conservatively than residential properties. The maximum permissible LTV depends on the property type and quality, the quality of the borrower, and the lender's perception of risk.
LTV = Loan Balance / Fair Market Value
- The Loan Balance is the requested loan amount or remaining principal balance (for a refinance) of all loans on the property, not just the first mortgage. When a property has more than one loan, the ratio often is called the Combined Loan-to-Value ratio (CLTV).
- The Fair Market Value is the appraised value or purchase price of the property or other collateral securing the loan. For a purchase transaction, lenders and investors use the lower of the two. Their logic is that an appraisal is really no more than an estimate of fair market value. The only true indicator of value is the marketplace. If the property sells for $500,000, then it is probably only worth $500,000.