To further illustrate the impact of holdbacks on investment property, check Tables 3 and 4. Table 3 illustrates a deal for an investment property without factoring in any holdbacks. It seems like a solid, bankable deal, with a DSCR at 1.48 and net operating income (NOI) of $66,764.

Table 4 provides the same deal with conservative holdbacks: 10 percent market vacancy, 4 percent management fees, and 2 percent interest reserves. As a result, the cash flow drops considerably to an NOI of $53,912. The DSCR drops to 1.19, below what many lenders consider a fundable transaction.

Commercial mortgage brokers should try to understand from their lenders how holdbacks are calculated in the underwriting before submitting a loan package. Although there may not be a set policy, loan officers should be able to provide insight into the process. Make sure you factor in some of these underwriting holdbacks, or you may be setting your deal up for failure.

4. Cap-rate maximums

Commercial mortgage brokers also should keep in mind that some banks have an absolute maximum capitalization rate that they use regardless of the appraisal.

For example, say a seller and a buyer agree to a purchase price of $4 million for an investment property. The sale price is based on a market cap rate of 7 percent with an NOI of $280,000, and the buyer is planning on a cash downpayment of 35 percent, or $1,400,000.

If the bank’s maximum cap rate is  8 percent, however, the property’s value goes down by $500,000 to $3,500,000. In addition, if the lender’s maximum loan-to-value is 65 percent (of the lower of the appraised value or purchase price), this could mean the maximum loan amount the lender will offer is $2,275,000 — 65 percent  of $3,500,000.

You and your client will have to find a solution for this problem. Options include: the seller reducing the purchase price by $500,000; the buyer coming in with additional money (in this example $1,725,000 versus $1,400,000); or some combination of the two. Otherwise, you have a dead deal — which unfortunately is the most likely scenario. This is why brokers must know if there is a set maximum cap rate before they submit any transaction.

5. Interest-rate stress-tests

Interest-rate stress-testing refers to the practice of using an interest rate on cash-flow analysis that is higher than what the borrower actually will pay on their loan. For example, a borrower may agree to a  5 percent interest rate on the loan itself, but the underwriter uses 7 percent in performing the cash-flow analysis. The loan would have to meet the typical DSCRs based on the higher rate to get approved.

Many lenders have an internal policy regarding whether, and how, they stress-test interest rates in the underwriting process. Your role is to learn as much as possible about the policy — particularly if your loan request has low cash flow.

Stress-testing is a common practice in banks that do variable-rate loans like the U.S. Small Business Administration 7(a) loan. These banks add 1 percentage point or more to the interest rate to determine the debt-service coverage. Banks that provide five-year and 10-year fixed rates, however, take a conservative approach and underwrite based on the higher rate.

As a commercial mortgage broker, you must be aware of whether your lender stress-tests rates and if so, by how much. Make sure you have this information as early as possible in the process.

Having a solid grasp of the details of the underwriting process will help commercial mortgage brokers pick the best lenders for their deals. By knowing if a deal is likely to make it through the underwriting process — or if it will get caught up by one of these five details — brokers can ensure a smoother journey for their clients, as well as better profitability for themselves. This knowledge may lead to more positive relationships with clients, in addition to improved closing ratios and income. 

Jeff Rauth is vice president of SB Capital, a nationwide direct lender for loan amounts as much as $13 million. SB Capital is an approved direct lender of the Small Business Administration Preferred Lender Program (PLP). With more than 14 years of xperience in the commercial real estate business, Rauth has worked at two commercial banks and as a commercial mortgage broker. Reach him at (248) 885-8797 or jrauth@sbcapital.com.

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