Underwriting is the foundation of any commercial mortgage — and it frequently is a lengthy, detailed and complex process. It starts with the collection of appropriate data, followed by an in-depth review and analysis. Next comes an interpretation of the data, which involves making assumptions, inferences and conclusions.
The questions asked, the degree of investigation and the depth of analysis conducted during the underwriting process may generate millions of dollars in revenue or millions of dollars in potential losses for the lending institution at hand. Commercial real estate is a costly investment, making an appropriate level of investigation crucial for the investor and the lender. Aggressive due diligence requires the buyer to spend time inspecting the subject property to mitigate the financial risks associated with the investment.
Aside from the seller’s disclosure of relevant issues, the responsibility is on the buyer to find any unidentified material issues that could influence the asset value and the ultimate closing of the transaction. Commercial mortgage companies often collaborate with counterparties, vendors, supply chains and technology systems, which can be vital in the risk-analysis process. Statements generated from entities unrelated to the transaction are frequently referred to as third-party reports. An impartial third party is usually a necessity for a successful transaction.
“Typically, title insurance is mandated by banking regulators and it is a requirement if the loan is sold to investors on the secondary market.”
A third-party report can be any study, investigation or other information compiled for the buyer or seller by a professional advisor who offers an objective opinion about the property. These reports protect all parties from making a poor investment decision. Lenders also rely on third-party reports to disclose all material information about the property.
The subject reports are varied in nature, require time to develop and can be costly. If they’re needed, they should be ordered as soon as possible. Mortgage brokers of all experience levels know that commercial real estate transactions are like snowflakes. Some deals may not require each of the third-party reports discussed here, while others may require additional investigation or unique iterations of these reports. Commercial mortgage lending is never a cookie- cutter process.
Appraisal and title
An appraisal is an opinion of value that derives the required equity contribution, loan-to-value ratio and approval of the loan. Banks that are supervised by the Federal Deposit Insurance Corp. (FDIC) are required to have procedures for selecting appraisers, as well as techniques for monitoring appraiser performance. In 2018, the FDIC created a new threshold and began exempting commercial real estate transactions of less than $500,000 from its appraisal requirement.
The appraisal process is driven by the Uniform Standards of Professional Appraisal Practice (USPAP). The purpose of USPAP is to provide guidance for developing and reporting appraisals, and its key provision is to assure independence and competency.
The most commonly used appraisal method in commercial real estate is the income approach, which bases the asset’s value on the income it generates. If the appraiser does not see the value the investor expects, the deal may fall apart. Generally, the investor will have their own perception of value, but they must be ready to support their opinion in quantitative fashion. A commercial mortgage broker should be proactive and provide the lender with as much information as possible to support the value.
Title insurance, meanwhile, is adaptable to meet the needs of a specific deal and will protect parties from issues with the chain of title to the subject property. There are two types of policies offered by title insurance companies. One is the lender’s policy, which protects the lender if there is a problem with the title. The other is the owner’s policy, which protects the buyer if issues are discovered.
A title company will conduct a deep dive into all recorded assignments, encumbrances or other liens that may have been filed against the property. The search concludes with a preliminary title report for the lender. Typically, title insurance is mandated by banking regulators and it is a requirement if the loan is sold to investors on the secondary market.
A title insurance company also may offer various policy endorsements, which protect against more than the standard title problems. There are about 100 different endorsement options that can cover such things as zoning conflicts, boundary errors and environmental concerns.
Surveys and conditions
A land survey is used to identify the existing attributes of a property. These include boundaries, rights of ways, structures, easements, encroachments, water features and other significant characteristics of the property.
A survey will establish the boundary based on the title commitment’s legal description, and it should identify any discrepancies between the existing description and the survey. The survey also will depict how survey-related exceptions to title affect the property. These are items that the title insurance will not cover and are normally found in Schedule B of the preliminary title policy. Circumstances dictate the need for a land survey. For example, if the lot is part of an existing subdivision, the survey requirements will have been previously met.
But if the transaction involves the purchase of raw land or the consolidation of two parcels, a survey will be required by regulators and secondary market investors.
A property conditions report is designed to identify issues with the asset’s physical condition. It may include an inspection of major building components such as heating and cooling systems, fire suppression systems, elevators, roofs, asphalt or sewer lines. The report will provide an estimated useful life for these items.
The use of this report is a frequent best practice for a lender, and it is often based on the size and complexity of the deal. It gives the buyer and lender a second opinion on the condition of the property, and it can confirm inspections completed earlier in the purchase process. The report is designed to be unbiased, giving the investor more credibility and negotiating power while helping to mitigate any lender concerns.
Lenders and regulators will have well-defined policies and procedures for environmental due-diligence tasks. If any level of potential contamination is suspected, an Environmental Site Assessment (ESA) report will look into soil composition, hazardous materials and other suspicious-looking features on the property.
Typically, this process includes a lender checklist, a public domain records search, and a Phase I or Phase II ESA report. If contamination is found, a costly and time-consuming cleanup process must take place, which may well kill the lender’s interest in the deal. Another aspect of environmental due diligence is a complete visual evaluation of all accessible areas of the property for the presence of asbestos and lead-based paint.
In addition, a seismic report may be required in certain states. This assessment will examine all structures to make sure they comply with procedures outlined by the American Society of Civil Engineers.
Market studies and more
A market study will take an in-depth look at the various economic aspects of an investment property. Specifically, it will look at supply and demand in the local market, and it will determine whether the property’s net operating income is likely to grow or shrink over time.
This study is optional and will depend upon the nature of the project. If the venture is unique (e.g., a hotel, golf course or another one-off project), the investor may need a formal market study to confirm their ideas and move the concept forward with other stakeholders. Market reports are generally expensive but usually worth every penny. They can be used to support investment assumptions such as absorption rates, rents and net operating incomes.
Zoning is a structure of legal codes used to develop various parts of a city or county, and it includes different requirements and constraints. The purpose of zoning is to protect existing neighborhoods. A zoning compliance report is a description of the zoning conditions and is often a necessary component of the acquisition process for developers, investors and lenders. In other words, it is an optional but common best practice. In the worst-case scenario, a serious code violation could impede or destroy a transaction. Escrow services are yet another option to consider. Real estate escrow companies act as neutral third parties to hold various deeds, documents and funds involved in the completion of the transaction. An agent deposits funds into an account on behalf of the buyer or seller. An escrow official will obey the directions of the lender, buyer or seller in a prescribed manner when managing the funds and documentation associated with the sale. ●