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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   August 2008

3 Keys to the New Underwriting Reality

By learning new underwriting standards, brokers can quickly gauge a deal’s potential

In today’s market, it is no secret that lenders have changed the way they approach prospective loans.

Lenders who are still liquid have tightened their requirements and moved to a more conservative style of underwriting. Lenders now scrutinize various elements of a deal -- the asset type’s liquidity, loan-to-value (LTV) requirements, the sponsor’s ability to make monthly interest payments and the exit -- more closely. These changes make many deals virtually impossible to close without a little creativity.

What does this mean for brokers? They look at loan requests every day and spend a substantial amount of resources and energy preparing packages to submit to lenders. By understanding the new style of underwriting, brokers can decrease the number of deals they work on while increasing their closed dollar amount.

Here are three aspects of underwriting that matter more than ever to lenders. Understanding these will help brokers quickly gauge if a deal is worth pursuing or is better left alone.

Loan to “quick” value

LTVs have always been at the forefront of underwriting loans. Commercial LTV and loan-to-cost percentages have dropped significantly in response to turmoil in the credit markets and the downturn in residential real estate.

When presented with a deal, the lender underwrites to a “quick” sale value. Lenders must consider the worst-case scenario. If they have to foreclose upon and own the property, it is important for them to know the price where the asset will trade quickly. The LTV is driven by this quick- sale number.

For certain asset types, a quick value has become difficult to obtain. For example, with a high-rise condominium development in Miami, logic says that lowering the price will create interest and a quick sale in the near future.

Circumstances are different in today’s market, however. Buyers realize that prices are continuing to drop. Sometimes prices even fall below a property’s replacement cost. Smart buyers will watch the price fall to a level where it makes sense for them to carry the asset until the market comes back.

Lenders have to account for this strategy, making the loan-to-quick-value ratio especially conservative for certain asset types, such as residential lots or condo buildings in hard-hit places such as Las Vegas, Miami and San Diego.

A solid exit

When commercial lenders look at loans, their exit normally consists of one of three things: refinancing once the asset is stabilized, a construction loan once it is entitled or approved, or a sale when it is completed.

The first two options involve another lender stepping in to move the project forward. Refinancing with a conventional loan has become more difficult. Income-producing properties are still attractive, however, because illiquid banks are looking for stabilized cash-flowing assets. Assuming that those assets have a debt-service-coverage ratio of 1.2 or greater, a refinance is still a viable option.

A refinance into a construction loan in the current market is another story. Construction lenders want to see 30 percent to 40 percent equity in the project and a number of preleases or presales to consider a construction loan. Banks have blacklisted some asset types in certain areas, such as high-rise condominiums or infrastructure for residential lots. If a loan has the stated exit as a construction loan for a product that is oversaturated in the market, the loan essentially has no exit. Lenders aren’t interested.

Oversaturation also makes the sale of an asset tricky. Real estate investors are scarce compared to a year ago, and those who remain know what they want and how much they are willing to pay. Financing for these buyers is difficult to obtain because of banks’ conservative stance; if the sale of the asset is the lender’s exit, the property must be attractive to buyers with the necessary equity to execute a sale.

A solid exit plan is crucial at a time when the market will not rescue projects like it has in the past.

Monthly interest payments

The last inquiry to make when taking an initial look at a deal is: Can potential borrowers make their interest payments each month?

Having the funds for a monthly payment can be achieved through cash flow from the asset or other cash flow. Paying interest current gives the lender comfort that borrowers have a steady cash flow and are not in a tough position financially. It also keeps the interest from compounding.

Accruing interest causes the loan balance to balloon rapidly. Even if lenders are willing to accept this structure, they will compensate for the interest accrual by reducing loan proceeds.

What does this mean to brokers?

As commercial brokers put together a loan package, they should look carefully at the project from the perspectives outlined above.

Questions to consider include:

  • Is the project located in a market where there is liquidity for the asset type?
  • Does the exit make sense given the state of the market?
  • Is the product unique and desirable?
  • Are there buyers for the asset type, and can they obtain financing? and
  • Can the borrower make monthly interest payments?

Once brokers start thinking along those lines, they can decipher quickly which projects have merit, which must be modified to be viable and which aren’t worth pursuing.

When considering if a loan makes sense as is or if it needs modifications, brokers should ask some vital questions:

  • Are the clients willing to cross-collateralize with other assets in their portfolio?
  • If it’s a refinancing, are they willing to get the current bank to subordinate a portion of their loan?
  • Is an additional cash infusion an option?
  • Is it possible to proceed with the project in phases, reducing the immediate need for funds?

When brokers recognize issues and look for ways to improve the situation right away, clients will view them as a reliable source for getting the job done. Brokers also will build a solid reputation with lending partners.

There are ways to get deals done, even in these tough times. Lenders are still looking to close loans -- they just want to be sure the loans that they do close can withstand the market, no matter which way it goes from here.  


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