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Banks and lenders determine the margin on personal needs in different ways. Larger regional or national lenders often have a set formula like doubling the amount on the borrower’s credit report — this is considered conservative. Others may use a 50 percent margin or a fixed amount (such as $500 per individual in the household per month). In addition, many lenders will add some margin for taxes.
On owner-user properties — where the borrower’s business occupies more than 51 percent of the subject property — underwriters calculate net personal needs based on the business’s cash flow. This affects the total cash flow available for debt service. That is why understanding how the lender calculates personal needs is critical, especially on loans that have low cash flow. In fact, incorrectly calculating personal needs is one of the biggest deal-killers out there.
To further illustrate the impact of personal needs on a lender’s deal-funding decision, check Tables 1 and 2. In these examples, the exact same deal is underwritten with personal needs calculated differently, assuming the borrower has $45,000 per year of minimum monthly payments on the credit report. In Table 1, the lender increases the $45,000 with a 50 percent margin, bringing the personal needs to $67,500. The debt-service- coverage ratio (DSCR), accordingly, is 1.36, which likely will result in an approved loan. In Table 2, the lender doubles the personal needs to $90,000. This reduces the DSCR to 1.16, which likely will get the loan declined as many lenders require it to be higher than 1.25.
2. Double accounting
In this context, double accounting refers to expenses that are reported more than once and thus inaccurately reduce the cash flow. Common examples include debts that are reported on the borrower’s personal credit reports and in the business financials, as well. These debts can be equipment or truck loans, business credit cards, lines of credit, etc. Even if these debts typically are in the company’s name, they commonly are reported on the borrower’s personal credit report, as well.
If a loan officer or a mortgage broker fails to catch this duplication and leaves the payments on the personal needs of the borrower, this could reduce the cash flow tremendously. As a result, the loan could be declined erroneously.
3. Holdbacks on investments
Commercial mortgage brokers and borrowers alike often make the mistake of not factoring in underwriting holdbacks into their cash-flow analysis on investment-property loans. These percentages should be calculated off the gross rent and subtracted out as an expense. Typical holdbacks include:
Market vacancy that commonly ranges between 3 percent and 12 percent or more
Management fees that are between 2 percent and 5 percent
Interest reserves that are between 2 percent and 4 percent
When dealing with holdbacks, there are several common questions clients ask, and commercial mortgage brokers should be prepared to answer them. These questions may include:
Why should I factor in vacancy when the property is 100 percent occupied?
Why should I factor in management fees if I manage the property myself?
Why should I factor in management fees for a triple-net-lease property in which the tenant is responsible for all expenses and management?
The answers to these questions are simple: Lenders view loans from a worst-case-scenario perspective, i.e., if the borrower defaults and the lender has to manage and own the building. If the lender had to take over an investment property, they would have to hire a management company, either because the property is out of their local area, out of their area of expertise or both. In addition, if the borrower defaults and/or the tenant went out of business, they would have to lease the property at market conditions, so they must factor in market vacancy.
Understanding what the lender uses for holdbacks before you submit your loan package can help you prescreen deals and save precious time for yourself and your client.
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