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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2005

Taking the First Step

Taking the First Step

The next time you get an approval on a commercial loan based only on vague property information or a credit score, you may want to proceed with caution. Many brokers have received this kind of approval and committed to a lender only to finally get a “no” or worse, a last-minute change of terms after waiting more than a month. What started as a great loan opportunity turned into a lost one, not to mention the loss of future business from a borrower who was also forced to wait only to lose money on upfront, nonrefundable fees.

Closing commercial loans is not rocket science. It’s a process, and the most-important step in this process is by far the first step — prequalification.

As we all know, there are different levels of analysis. Some lenders just look for property type, credit scores and loan amount and will give you an affirmative answer without looking deeper into the loan file. This is not in-depth analysis. When the proper analysis is done later in the process, problems — many unsolvable at this point — can arise. If you don’t understand how to properly prequalify a loan, you may not know if this is happening until it’s too late.

The good news is that preventing this scenario from happening to you — or happening again, for many of you — is quite easy. The factors to consider in proper prequalification analysis are borrowers’ credit history and financial status; property cash flow; and property value, which includes comparables and cap rates. Whether it is you or your account executive who prequalifies the loan scenario, the buck stops with you, the person brokering the loan. You must ensure it’s being done right.

Credit history and financial status

Most lenders have a requirement for scores, history and liquidity. Personal debt-to-income ratio is becoming less prevalent in commercial underwriting guidelines, but credit history is still a driving force in most cases.

It is important to understand that many lenders will pull a borrower’s credit at the beginning and end of the loan process. Always advise clients not to make major changes to their credit picture that could lower their scores until after closing.

Property cash flow

The Debt Service Coverage Ratio (DSCR) helps determine the level at which the property can support the debt. It is calculated as net operating income (NOI) divided by the annual debt service (12 months of principal and interest payments). The NOI is typically taken from actual, historical data and not by a listing agent’s (sometimes unrealistic) future projections for the property.

Underwriters will have add-ons to apply to the property cash flow, i.e., minimum vacancy factor, management fee, replacement reserves. Your account executive should discuss these with you. A common minimum DSCR is 1.2, but each lender is different. The higher the better is a good rule of thumb when it comes to DSCRs.

Property value

Regardless of any other factor, a lender will lend only on what the property is worth. In most cases, loan to value (LTV) is based on the lesser of the sales price or property value.

How the property is valued depends on several things. Two key items you can check initially are comparables and cap rates. Verifying these will help ensure that you aren’t a week away from closing with an appraisal that comes in $200,000 short.


For purchases, real estate agents in- volved should be able to show that the sales price they have negotiated on behalf of their clients is in line with market values by providing you with sales comparables. Make sure the properties they are using for sales comps are of similar property type (for example, don’t use a four-unit residential property as a comp for a six-unit commercial property), condition and location. These comps should be properties that have been sold, not properties still on the market.

Once you have a few comparables in line with your subject property, look at price per unit or per square foot in comparison with the subject property. If the comps are selling for $98 per square foot and your subject property’s sales price is $124 per square foot, your property may be overvalued.

Rental comps for similar properties may play into the appraiser’s income approach and will also be used by the underwriter to ensure rents for your property are not overmarket. If the appraiser determines that your property’s rents are higher than current market rates, the underwriter will base the NOI (and thus DSCR) on current market rents only. This can drop the DSCR and leave you with a lower-than-expected loan amount.

Cap rates

The cap rate is often misunderstood. Cap rate equals NOI divided by property value or sales price (whichever is less). There is no minimum number for the cap rate; it will vary depending on property type, condition and location. While it is typical in today’s market to see a cap rate of 6 percent to 7 percent in many California markets, a similar property in a rural Iowa market may have a cap rate of 14 percent or more.

The appraiser will determine what the market cap rate is and apply it to the NOI of the property. You can do a similar calculation yourself before valuable time is lost. Just use the cap rate for the property’s market and apply it to your NOI. If you see a big discrepancy between the sales price and the value you determined by using the cap rate, ask the real estate agents how they arrived at the sales price.

•  •  •

These various factors can greatly impact the chances of closing loans for your clients. Closing a commercial loan doesn’t have to be difficult, but it doesn’t solely start — or end — by shopping for the lowest rate or fastest close time.

By analyzing these factors, your account executive should be able to quickly determine if your loan has a high chance of closing. And by checking each of these factors yourself, you can head off the many pitfalls a commercial loan can fall into on its way to funding.

Just knowing how to check these factors will aid you in finding out if lenders really think they can close your loan, so don’t be afraid to ask if they don’t ask you.

Taking the first step by properly prequalifying increases the chances of taking the final step — closing. 


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