LESSON 6. Commercial Mortgage Underwriting

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1 LESSON 6 Commercial Mortgage Underwriting Note: Selected readings can be found under "Online Readings" on your Course Resources webpage Assigned Reading 1. UBC Real Estate Division BUSI 221 Course Workbook. Vancouver: UBC Real Estate Division. Lesson 6: Commercial Mortgage Underwriting 2. UBC Real Estate Division Real Estate Finance in a Canadian Context. Vancouver: UBC Real Estate Division. Chapter 8: Commercial Mortgage Underwriting Recommended Reading 1. Clinkard, J. 2009, February 11. "As vacancy rates rise, Canada's commercial construction outlook dims". Daily Commercial News. 2. Cushman & Wakefield LePage Outlook '09 Annual Market Review. Toronto: Cushman & Wakefield LePage, Inc. Learning Objectives After completing this lesson, the student should be able to: 1. describe the unique nature of commercial covenants and define gross, net, and triple net leases; 2. discuss why commercial lending activities are less uniform that residential lending activities; 3. list the factors that influence the qualification of commercial borrowers; 4. analyze and calculate the cash flows relied on for commercial underwriting: gross potential rental income, vacancy and bad debts, operating expenses, and net operating income; 5. identify and discuss the income lending constraints used in commercial underwriting: safety margin, debt coverage ratio, and loan-to-value; 6. apply and calculate the maximum commercial loan using the underwriting criteria; and 7. describe the unique nature of commercial covenants. 6.1

2 Lesson 6 Instructor's Comments Commercial mortgage underwriting is used in situations where residential property is not owner-occupied (income-producing residential) and for all non-residential property, which is predominantly incomeproducing. Commercial properties include the following: single family dwellings that are not owner-occupied; multiple family dwellings that are not owner-occupied; industrial; manufacturing; retail; office; and mixed use buildings that have a combinations of the above. In the past, there were strong distinctions between the property types. In recent years, mixed-use buildings have become more prevalent. Commercial underwriting considers the income producing capacity of the property as well as the borrower's income and the value of the security. The underwriting criteria that lenders use will vary according to a wide variety of factors including: the type of building, type of tenant, interest rates, vacancy rates, length of term, and economic conditions. In prosperous economic times, lenders are more permissive with respect to the lending criteria. However, in more economically volatile times, lenders are very cautious and conservative with respect to loan-to-value ratios and debt coverage ratios. 6.2

3 Commercial Mortgage Underwriting Review and Discussion Questions 1. Kelly Elm, the owner of the Village Circle Mall, has applied to your bank for a mortgage. As the commercial loans officer, you must evaluate his loan application. Your initial investigation has found the following issues in regards to Kelly's application. For each of these issues, discuss what effect they may have on the attractiveness of Kelly's loan application and describe any additional issues that may need to be considered as a result of this effect. In your answer, define any underlined terms. (a) (b) (c) (d) The mall's "efficiency ratio" is 80% (which is close to the market efficiency ratio for similar malls). The mall is anchored by a large supermarket which accounts for 55% of the mall's net leasable area (this supermarket is not a "Triple A" tenant). This supermarket has 8 years remaining in its lease with a considerable "profit rent". A large portion of the income on the mall's financial statements comes from percentage rents. One tenant (a dentist) is paying above-market rental levels, as a result of Kelly amortizing the cost of the significant improvements made to these premises into the rental schedule. 2. You have been asked to provide a long-term loan on an industrial project which, when completed, is projected to have a total gross potential rental income of $124,800 per annum. The developer requests an $800,000 mortgage loan at 11.25% per annum, compounded semi-annually with monthly payments to be fully amortized over 25 years. Given the current high vacancy rates in the industrial real estate market, you specify that the full loan of $800,000 will only be advanced upon completion and satisfactory leasing. The amount of the loan will be restricted by your institution's maximum debt coverage ratio of (a) Assume that all leases are fully net leases (the tenant pays all operating expenses except management), and that the building comprises 24,000 square feet of rental space to be let at $5.20 per square foot. Management expense is estimated to be 5% per annum of effective gross income. It is estimated that vacant space will cost the landlord $1.80 per annum per square foot in operating expenses. (b) Determine the maximum loan you would recommend if you expect the vacancy to be 20% and you use a debt coverage ratio of Explain why investors in income-producing properties may find it financially advantageous to borrow a part of the required capital even though their own funds might be sufficient. 6.3

4 Lesson 6 ASSIGNMENT 6 CHAPTER 8: Commercial Underwriting Marks: 1 per question. 1. Which of the following statements are TRUE? A. In commercial underwriting, the lender focuses on the income from the property as well as the applicant's general financial strength and track record. B. The underwriting process for commercial properties is identical to that of residential properties. C. The basis of commercial lending policy is to lend on property that has sufficient annual revenue to pay a portion of property operating costs as well as the mortgage payments, while still having a margin of safety. D. The revenue and expense data used in commercial underwriting may not be derived from annual projected cash flows, and must instead be based on actual historical cash flows. (1) All of the above statements are true. (2) Only statements A and C are true. (3) Only statements A, C, and D are true. (4) Only statements B and D are true. THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Spencer, a mortgage lender, has received an application for a first mortgage loan on an apartment building that will generate a gross potential rental income of $80,000 per year. Market conditions indicate that a 5% vacancy allowance and a 2% bad debt allowance are appropriate for this type of building and for this level of rents. The landlord's share of operating expenses is expected to be $16,000 per year. Spencer requires a safety margin of 25% of net operating income. 2. What is the maximum monthly mortgage payment that could be made using the safety margin constraint? (1) $3, (2) $3, (3) $4, (4) $4, Spencer wishes to calculate the maximum loan the property will support given current mortgage rates of 6% per annum, compounding semi-annually with a 25-year amortization and monthly payments. What is the largest loan the net operating income will support rounded to the nearest ten dollars? (1) $570,480 (2) $586,110 (3) $638,880 (4) $683,

5 Commercial Mortgage Underwriting 4. Consider the following statement: "The safety margin is used to ensure that income from a property is sufficient to cover required payments". This statement is: (1) true, because the safety margin sets a maximum on the value of the property which can be obtained. (2) true, because the safety margin limits the percent of the net operating income that can be used to make mortgage payments. (3) false, because the required mortgage payments do not depend on the income from a property. (4) false, because the safety margin is used to ensure that the income from the borrower's other properties is sufficient to cover required payments on a new property. 5. When appraising commercial properties with direct capitalization, the appraiser will: (1) compare to residential properties in the same location that have recently sold in arm'slength transactions. (2) use the effective gross income calculated from the revenue and expense analysis to estimate the property's market value. (3) apply some judgement when considering comparables. (4) estimate the market value by dividing the market capitalization rate by the net operating income. 6. Mr. and Mrs. Paterson have approached a lender to obtain a $675,000 mortgage loan to purchase a pet shop. Current interest rates are 7.25% per annum, compounded semi-annually. Monthly payments will be amortized over 20 years and the loan will have a 5-year term. The lender has determined that the property will generate an annual net operating income of $80,000. To obtain lending value, capitalize the net operating income at a rate of 8% per annum, compounded annually. If the lender applies a 75% loan-to-value ratio and a 1.2 debt coverage ratio, what is the largest loan that Mr. and Mrs. Paterson can obtain (rounded to the nearest hundred dollars)? (1) $750,000 (2) $675,000 (3) $670,700 (4) $708, Which of the following statements regarding operating expenses is FALSE? (1) In rental apartment properties, the landlord is often responsible for all expenses. (2) With long-term occupation leases, the contract may require full or partial escalation of some or all expenses to the tenant. (3) In some non-residential leases, the landlord will be responsible for structural repairs including the exterior walls, roof, and structure. (4) "Net net lease" is the standard term used when discussing leases in which operating expenses are paid by the tenant. 6.5

6 Lesson 6 8. Using the following information, calculate the effective gross income of the property. The property has 20 suites, each leased at $1,000 per month. Each suite has one parking stall, leased at $500 per year Annual revenue collected from laundry and vending machines is $3,500 Vacancy allowance for the suites is 5% Vacancy allowance for parking is 10% (1) $240,500 (2) 253,000 (3) $378,000 (4) $237, In the commercial underwriting process, which of the following factors are used in the qualification process? A. Mortgage and real estate market conditions at the time of the application B. The applicant's management capabilities C. The strength of the covenants of tenants resident in the property D. The applicant's track record (1) All of the above are used in the qualification process. (2) Only B, C, and D are used in the qualification process. (3) Only A and D are used in the qualification process. (4) Only A and B are used in the qualification process. 10. Calculate the per annum reserve on an apartment with 40 suites, each with a washer and dryer. Each washer and dryer combination has a total replacement cost of $3,500 and is expected to last twelve years. (1) $11, (2) $23, (3) $5, (4) $17, A debt coverage ratio (DCR) of greater than one implies: (1) there is sufficient borrower's income to service the given mortgage payment. (2) there is insufficient borrower's income to service the given mortgage payment. (3) there is sufficient property income to service the given mortgage payment. (4) there is insufficient property income to service the given mortgage payment. 6.6

7 Commercial Mortgage Underwriting 12. Queenie Spades has approached the Happy Trust Company to borrow $580,000 through a second mortgage secured by his office building. The outstanding first mortgage on this property was written 8 years ago for $725,000 at a rate of j2 = 7%. The loan called for level quarterly payments of $16,128.26, sufficient to amortize the principal over the loan term of 22 years. Annual net operating income for this building is $162,700. The Happy Trust Company is willing to make a second mortgage loan at a rate of j4 = 13.5%. This loan requires quarterly payments sufficient to fully amortize the principal over a term of 10 years. The trust company requires a debt coverage ratio for the total of first and second mortgage payments of What size loan will Queenie qualify for, given the above conditions? (1) Exactly $580,000 (2) Substantially greater than $580,000 (3) Substantially less than $580,000 (4) Cannot be determined from the information given 13. Joe Cup is the owner of "The Coffee Shop", the local coffee shop in Trail, BC. Joe wishes to diversify his business by running sightseeing tours, but requires an additional $300,000 in capital. The local bank, Trail Trust, will provide Joe with financing in the form of a mortgage loan on the coffee shop, but will not accept a debt coverage ratio of less than 1.5. Payments on the loan are to be made quarterly, and the loan will be amortized over seven years at an effective annual interest rate of 7%. What minimum net operating income must "The Coffee Shop" have in order for Joe to obtain the financing? (1) $81, (2) $36, (3) $20, (4) $35, THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Paul Switzer requires assistance in determining the maximum loan that he could be granted on Arbutus Place, a commercial building with a lending value of $6,250,000 and a net operating income of $450,000 per year. The lender, Offshore Bank, requires a debt coverage ratio of 1.25 and a 65% loan-to-value ratio. The loan will be amortized over 20 years with annual payments and an interest rate of 8.5% per annum, compounded annually. 14. What is the maximum loan Paul could expect to receive under the loan-to-value constraint? (1) $4,062,500 (2) $3,770,000 (3) $1,222,602 (4) $5,000,

8 Lesson What is the maximum loan (rounded to the nearest dollar) Paul could expect to receive under the income constraint? (1) $3,441,176 (2) $4,258,501 (3) $3,406,801 (4) $4,654, A percentage lease is typically usually used in: (1) retail leases (2) office leases (3) industrial leases (4) residential apartment leases 17. James has enough cash saved to purchase a small apartment building. However, he is considering obtaining a loan for a portion of the purchase price. He may choose to do this because he: (1) knows that diversifying his portfolio will not reduce risk. (2) anticipates that there will not be an increase in the rate of inflation. (3) will have additional equity available for other activities. (4) is guaranteed that he will be able to use fixed cost debt to increase his overall return on this investment. 18. Which of the following statements is FALSE? (1) Effective gross income is the expected annual gross income from the property, at 100% occupancy, based on the type of lease arrangements commonly used for this type of property. (2) Factors to be considered in estimating the vacancy and collection loss allowance include past performance for the subject property, age and quality of the subject property, economic state of the area, and type and quality of tenants. (3) Net operating income represents the income available to service the mortgage debt and provide a return on equity. (4) Fixed expenses are costs that, in the short-run, remain constant throughout the period, independent of the level of occupancy. 19. Commercial lenders prefer a recourse mortgage (over a non recourse mortgage) because: (1) the lender has the right to go after borrower's other assets to settle the claim in the event of default. (2) in the event of default, the lender is limited to the value of the property itself to satisfy outstanding amounts. (3) this type of loan will have a typical loan-to-value ratio of up to 75% of value. (4) recourse mortgages guarantee 100% reimbursement in the event of default. 6.8

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