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   ARTICLE   |   From Scotsman Guide Residential Edition   |   September 2007

Small-Balance Solved

Knowing why small-balance commercial deals get derailed can help get them on track

If you’re like many residential brokers, you’ve probably been thinking about making a move into the commercial market. You may have even tried a small-balance commercial deal or two, but you walked away discouraged by the outcome.

If you follow some general tips, you can take the mystery out of commercial lending and start closing deals. The key to keeping commercial deals on track is to know what common issues to watch for and how to handle them.

Stated income

With a stated-income product, you have only one chance to state your borrowers’ income. Changing the stated income after the deal has been submitted will typically result in the lender requiring your borrowers to submit two or three years’ worth of full financials.

As such, it’s critical to understand the product’s underwriting guidelines and to include all eligible income on the application. For example, does your lender prefer to see monthly or annual income? Will it look at the borrowers’ global cash flow? Will it request income figures from the entire household, or just from the borrowers?

Be sure to ask about all sources of your borrowers’ income. Are they self-employed or wage earners? Do they get an annual or quarterly bonus? Do the borrowers have any additional income-producing properties? 

Ensuring you have accurately calculated the income on investment properties is critical. It will save you time and reduce the chance of post-approval fallout. Even on a stated-income loan, it’s best to review your borrowers’ real estate tax schedules or operating statements. You will need to know the gross rental income as well as any other income produced by the property. You will also need to know the standard operating expenses, one-time expenses and the interest and depreciation expense.

Using the statements or schedules, you can calculate the borrowers’ net operating income (NOI). NOI, the property's annual gross income minus operating expenses, is the figure you use when reporting the income on the subject property.

Gross income includes rental income and any other associated income. Operating expenses include maintenance, insurance, management fees, utilities and property taxes.

Cash flow

It’s always best to prequalify your borrowers prior to submitting a file. Again, doing so saves you time and reduces the possibility of a post-approval decline. To prequalify your borrowers on an investment property, you should know not only the NOI but also the proposed mortgage principal and interest.

Know your lender’s debt-service-coverage ratio (DSCR) requirements. Most lenders seek a DSCR of at least 1.25, which means the lender is looking for $1.25 in net operating income for every $1 of mortgage payment. A DSCR lower than 1 would indicate that the property does not produce sufficient income to cover the monthly mortgage payments.

In addition to reviewing the subject property, many small-balance commercial lenders will review the personal cash flow of the borrowers to ensure they have the capacity to step in and take over the payments, if necessary. For most lenders, the borrowers’ personal monthly debt cannot exceed 40 percent of their income, which means for every $1 in debt, the borrowers would need at least $2.50 in income.

Some lenders have specialists available who will walk you through the process by phone before you submit the file. Take advantage of that service when available. There may be something you’ve missed in the application and a second set of eyes can’t hurt. Further, at this stage, a motivated lender may be willing to negotiate rates.  

Property values

Your borrowers must provide an estimated value of the property. This can be tricky. Unlike residential properties, it is not as common to find two identical commercial properties in the same area. Even if there are two in the same area, factors such as parking, location and improvements come into play when determining property values.

It is helpful to have an understanding of the market to determine a realistic property value. Things to consider when estimating the property’s value include comparable sales, purchase price, tax assessed value, property improvements, location and, in the case of investor properties, rental income and operating expenses.

A full appraisal is often required and the fee is usually due when the application is submitted. Some lenders may choose, though, to conduct a thorough evaluation of the property, coupled with a physical inspection, to determine its value. The two methods typically draw similar conclusions about the property’s value. Because there is little difference in the end result, opt for the less-expensive lender evaluation if possible, as full appraisals can cost as much as $6,000.

Titles and liens

With so many streamlined commercial referral programs in today’s market, there is no need for you to pull title on the property. That means, however, that title issues may surface once the application is in process.

Some lenders will help facilitate the reconciliation of title to salvage the loan. If you are working with borrowers who have an existing issue before submission, you may want to confirm that the lender will clear up the title issue on behalf of the borrowers and if so, if there is a fee.

It’s important that your borrowers disclose all existing liens on the property. Even if a private-party lien does not appear on the borrowers’ credit report, it will be reflected on title. Failure to disclose all existing liens in the initial application may cause red flags with the underwriters later in the process.

Environmental issues

The current and past use of a property may influence its acceptability to a lender. Areas of particular concern include the past or present use of above-ground or underground storage tanks, regulated substances or known environmental contaminants. Properties that usually raise a flag with lenders include gas stations, auto-repair shops, commercial printers, hospitals, laboratories, wineries and warehouses built before 1990.

In addition to relying on information provided by the borrowers, lenders rely on public records and property zoning to ascertain the environmental sensitivity of the subject property. Most require a Phase I or Phase II environmental survey if the property is considered environmentally sensitive. The completion of these independent surveys can add weeks, possibly months, to the loan process.

In addition to the surveys, lenders require an environmental insurance policy to cover the loan should an environmental issue surface later. Sometimes they’ll forgo the surveys and require only the environmental insurance. This can save you valuable processing time, so be sure to find out if your lender has this option before submitting your file.

In either case, if the environmental insurance provider does not approve the property for coverage, the loan will be declined, regardless of how strong your borrowers are. Find out what your lender requires with regard to environmental surveys before submitting the application, and educate your clients accordingly.

Borrowers’ concerns

Like in the residential industry, there are times when commercial borrowers change their mind safter the application has been submitted.

One reason they change their minds is because of fees and penalties. If your borrowers seek to refinance an existing loan, they may face a prepayment penalty from the original lender. Be sure to ask them about this going into the transaction. If the existing interest rate is high, it might still make sense to take out the old loan.

If the interest rates are comparable and your borrowers’ objective is to access untapped equity in the property, there may be another option. Some lenders offer second-lien financing on commercial real estate, including commercial equity lines of credit. In addition to offering flexibility, equity lines and loans offer access to equity without incurring prepayment penalties on the existing first lien.

No matter what, know your lender’s guidelines if the borrowers want to withdraw the file. Some will match a comparable offer. It doesn’t hurt to ask as it could save the deal for you.

Time can also be a drawback to commercial loans. The average small-balance commercial transaction takes 45 to 60 days. Ensure that your borrowers have a realistic expectation about the processing time and that they are aware of the things that can delay the file.

Incomplete applications are a big cause of delay. Submitting a complete application is the first step to ensuring a timely closing. If your lender has a pre-submission review service, take advantage of it. A quick review will ensure all of the relevant information is included.

Title issues tend to cause processing delays, as the issues can be complicated and take time to unravel. Be sure to notify the borrowers as soon as a title issue has surfaced, to help reduce their anxiety about the delay.

The most common reason files are delayed, however, is because borrowers don’t provide information in a timely manner. Some lenders can provide you with a list of their most-common requirements. Providing the requested materials when submitting the application can put your deal on a fast track.

•  •  •

Understanding and anticipating potential “derailers” will help ensure a smooth experience for you and your small-balance commercial borrowers. This means you should incorporate critical questions into your loan interview, know your lender’s guidelines and know how to capture all eligible income. Further, you must guide your borrowers through the property-valuation process. Ultimately, your goal is to ensure that you understand their financing objectives and that you provide the best value to meet their small-balance commercial financing needs.



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