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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2006

The Ins and Outs of Conduit Underwriting

Help your borrowers understand the requirements of conduit lenders

It is common in the conduit market for a prospective borrower to request loan proceeds that exceed the underwritten loan amount. Several factors cause this disparity. Unfortunately, however, many borrowers are unfamiliar with these factors.

Brokers should know the standard requirements of conduit lending so they can properly advise their borrowers on what constitutes realistic loan terms.


The most frequently overlooked consideration that impacts loan proceeds pertains to reserves or escrows. A conduit lender will require that property taxes and property insurance be escrowed on a monthly basis.

When calculating the loan request, borrowers typically only take this particular property escrow into consideration. The problem is that they fail to account for other customary reserves, which include deferred maintenance, capital-replacement reserves and tenant-improvement and leasing commissions.

As a broker, you must understand and explain to your clients the nature and purpose of these various reserve requirements. The deferred-maintenance reserve represents a one-time upfront reserve for repair items identified in a property-condition report.

The capital-replacement reserve is an ongoing monthly reserve for capital or structural items. For example, on multifamily properties, conduit lenders generally underwrite a standard $250 per unit for the replacement reserve. Newer apartments may reserve as low as $200 per unit, while apartments utilized for student housing will require a higher reserve of $300 per unit.

These per-unit capital-replacement reserve amounts are imposed regardless of the actual expenses incurred by the borrower to operate the property. With office, retail, industrial and self-storage properties, the replacement reserve will be determined on a square-footage basis. The amount per square foot typically will range from $0.10 to $0.25.

In addition, a reserve fund will be established for tenant improvement work and leasing commissions. The leasing-commission reserve is intended to account for leases that will terminate before the loan’s maturity date. Because these terminating leases can negatively impact loan proceeds, this reserve is important to the lender. The reserve ensures that adequate funds are available to re-tenant the property as leases expire and leased space goes dark.

The conduit underwriter will deduct from the overall reserve amount, which results in a reduction in the loan. As a result, the borrower will receive a well-structured loan that nevertheless has a lower-than-expected loan amount. Although the borrower often does not see the logic to the lender’s calculation of the loan amount, there are standardized, methodical underwriting guidelines. They are rigidly adhered to by most conduit lenders for virtually all conduit loans.


Similar disparities exist in the ways lenders and borrowers measure the income from commercial leases. Borrowers often believe that a space lease is long-term when it has three years remaining with two five-year renewal options.

The conduit lender sees it differently. It will assume that the tenant will vacate in three years, unless it sees an executed lease extension before closing. For underwriting purposes, this kind of lease is considered short-term and assumed to expire in three years.

Similarly, even if the rent is expected to increase during the term of the lease, the conduit lender will not give credit to those increases when calculating net cash flow unless the tenant has an investment-grade credit rating.

Fees and contracts

The property-management fee is one of several other issues can derail a conduit loan if the borrower is seeking maximum proceeds. Borrowers must be aware that a conduit lender will impose a minimum management fee for underwriting purposes. Even if a borrower self-manages and has no management fee — or pays a relatively low management fee for a third-party manager — the conduit lender will underwrite a standard 4-percent or 5-percent management fee.

The lease is another potential cause for misunderstanding if it represents an above-market rent. In performing the market-rent analysis, the conduit lender will place more weight on the appraisal than on the actual rent. If the building rents are deemed above-market, they w likely ill be marked to market. The contract rent will be deemed lower for underwriting purposes.

Each time there is a reduction in cash flow, a negative variance will exist between the requested loan amount and the actual amount offered.

To keep your borrowers from being caught off-guard with the final loan offer, educate them on what to expect throughout the underwriting process. Remind your clients that the conduit lender’s underwriting is designed to structure a loan for a property that might not otherwise be able to receive financing. 


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