Sound Underwriting Principles
for Commercial Real Estate Project Financing
Commercial real estate loans are divided into two categories: credit-based loans and project financing. Credit-based loans are secured by real estate, but repayment comes from a source other than the collateral, such as business operations. With project finance loans, the cash flow that services the debt originates from the real estate securing the loan.
The paramount question a lender needs to ask for a project finance loan is no different from general Commercial and Industrial (C&I) Lending, “How will the loan be repaid?” The difference is that because the subject property is the source of repayment, the property must be analyzed in detail as a standalone business. The business elements needed for a thorough analysis include:
• Property Cash Flow
• Property Value
• Borrower’s Financial Condition
Property Cash Flow
For income properties, the bottom line, Income – Expenses, is called the Net Operating Income (NOI). To determine NOI, review the property’s historical operating statements and use current market information to prepare a pro forma NOI.
Reviewing the Rent Roll
A lender must carefully review the rent roll. The rent roll is a monthly report that summarizes the current leases by identifying the current tenants and their spaces, the lease rates and other information (such as expense reimbursement, etc.). To derive the “back of the envelope” calculation, multiply the monthly rental income by 12. While this is a good start, this approach is incomplete, as it does not account for vacancy or non-rental income. It is sound practice to verify the rent roll. Read the leases (all leases if there are a small number of tenants or a sample if there are many) to verify the lease terms are accurately reflected.
Verifying the Expenses
Pay attention to the aggregate level of expenses, commonly measured by expenses per square foot for commercial properties, expenses per unit for multi-family properties or the expense ratio (expenses / Effective Gross Income). Each market and property type has a generally accepted “market expense level” that is a consensus figure to which most market participants (brokers, appraisers, borrowers and lenders) will underwrite. While individuals will have different opinions (is the proper expense level 43 percent or 45 percent?), most market participants will quote a small range that provides a useful gauge. Lenders need to compare the subject property’s expenses against that range. For example, if a borrower is reporting an expense ratio of 35 percent when the market consensus is nearer to 45 percent, then the borrower may not be reinvesting sufficiently into the subject property.
It is good practice to verify the expenses. Review copies of the real estate tax bill, insurance bill and utility bills for the last 12 months. It is usually impractical to review all of the expense receipts (how many times did maintenance personnel go to Home Depot?), so it is important to develop underwriting standards to apply to individual line items and to expense levels as a whole. For example, a lender’s underwriting policy may be to underwrite multi-family loans with minimum Repair and Maintenance expense of $400 per unit. Many appraisal firms or brokerages publish expense surveys that are useful in developing underwriting standards.
Utilizing the NOI Information
Now the lender has underwritten income and expenses and has determined the subject property’s NOI. How is this information useful?
It is prudent for the subject property’s income be sufficient for the debt service payments, plus a cushion in the event the subject property’s NOI declines. To measure this, the lender will calculate a Debt Service Coverage ratio (DSC).
DSC = NOI / Annual Debt Service
Lenders will underwrite different property types to different DSCs, reflecting different property type risks. Multi-family, which is considered the least risky, will generally have a lower DSC, while hospitality, generally considered the most risky, will have a higher DSC. DSC guidelines are typically:
| Property Type | Minimum DSC |
| Multi-family | 1.15 |
| Commercial | 1.25 |
| Hospitality | 1.40 |
Property Value
By federal law, all banks are required to have an appraisal to make a loan secured by real estate. Some institutions have staff appraisers and perform appraisals internally. Most lenders use third-party appraisers. Lenders are required to formally review each appraisal to determine if it meets the institution’s appraisal standards. Most large and medium-size institutions have appraisal departments that serve this function. Smaller institutions may rely on underwriters or loan officers to review the appraisals, though it is not a recommended practice to allow commissioned loan officers to perform the appraisal review.
The standard appraisal methodology requires the appraiser to develop three approaches to value and then reconcile the approaches to determine a final value: Income Approach, Sales Approach and Cost Approach.
Income Approach
The appraiser calculates the subject property’s income (NOI) using historical operating statements and current rents, taking into account measures such as market rents, market vacancies and market expense levels.
Next, the appraiser identifies “sales comps.” These are comparable properties that have sold recently. The appraiser will extract capitalization rates (cap rates) from these transactions.
A cap rate is a measure of the price paid for a given income stream (the NOI). It is calculated using the following formula and is expressed as a percent (for example, the sales comparable sold for a 7.0% cap rate):
Cap Rate = NOI / Sales Price
The appraiser will identify all sales comps in the appraisal and adjust the cap rate, because no comparable properties are identical, to determine a cap rate for the subject property. The final step is to apply the cap rate to the subject property’s projected NOI:
Income Approach to Value = NOI / Cap Rate
Sales Approach
The assumption inherent in the sales approach is that investors will not pay more for a property if they can purchase a similar property for a lesser price elsewhere. The basic unit of measure for this approach is sales price per unit for multi-family properties, sales price per square foot for commercial and sales price per room for hospitality. For example, investors will not pay $100,000 per unit for a multi-family property when they can purchase another for $80,000 per unit.
The appraiser gathers comparable data for similar properties that have recently sold. Like the income approach, the appraiser will need to adjust the data and determines a price per unit. The appraiser then multiplies the price per unit by the number of units to determine the sales approach to value.
Cost Approach
The last approach is the cost approach. In many instances, this approach is not included in an appraisal because it can have limited relevance, especially if the subject property is old or is located in an area that has had a limited amount of new construction.
Reconciling teh Approaches
The last step is to reconcile the three approaches to value. The appraiser will generally give the greatest weight to the approach that has the best supporting data.
An appraisal requires subjective reasoning, and it is not uncommon to have different appraisers perform appraisals on the same property and generate different values. Lenders must have familiarity with appraisal techniques and be able to make sound judgments based on the data the appraiser generates.
To ensure sufficient collateral coverage, lenders will generally lend an amount that is less than the value of the collateral. This is measured with a Loan to Value (LTV).
LTV = Loan Amount / Value of the Collateral Property
As with DSC, lenders will underwrite different property types to different LTVs, reflecting the different risk characteristics. LTV guidelines are typically:
| Property Type | Maximum LTV |
| Multi-family | 80% |
| Commercial | 70% - 75% |
| Hospitality | 65% |
Determine the Borrower's Financial Condition
For project finance lending, the income from the collateral property is the primary source for debt repayment. Prudent lenders will also examine the borrower’s financial condition to gauge the support the borrower brings to the transaction. Prudent lenders should bear the following principal in mind: a good borrower will rarely make a bad loan good, while a bad borrower can make a good loan bad. When underwriting a borrower, a lender should review the credit report and analyze the borrower’s financial statements and tax returns.
Reviewing the Credit Report
When reviewing a credit report, it is important to look past the FICO score. In general, FICOs are a good indicator of a borrower’s long-term ability to effectively manage debt, but FICOs do not predict a change in a borrower’s financial condition. A borrower with a deteriorating financial condition can successfully maintain a high FICO score while a borrower with a low FICO may have suffered a financial setback but has since regained control. Look at the payment pattern of reported accounts. Does the borrower have a history going back at least two years without late payments? Are there any derogatory items, such as accounts sent to collection, legal judgments, liens or bankruptcies?
Reviewing the Financial Statements and Tax Returns
In reviewing a borrower’s personal financial statement, it is important to consider liquidity and net worth. More liquidity is better. A lender may gain comfort with a marginal loan if the borrower owns a large amount of liquid assets. Many lenders require specific amounts of liquidity, such as three or six month’s worth of debt service payments.
When considering net worth, look at the borrower’s total financial position. A $2 million net worth based on a $4 million balance sheet is very different from a $2 million net worth based on a $50 million balance sheet. It is important for a lender to pay attention to the borrower’s other real estate investments. Most lenders require borrowers to report information about their other real estate investments and then calculate a portfolio LTV and DSC to determine if the borrowers’ other real estate will be a source of strength or weakness. For example, a borrower with a large portfolio that is leveraged to a 90 percent LTV and has a 1.10 DSC does not have much margin for error, whereas a borrower whose portfolio has a 50 percent LTV and 2.0 DSC has far more cushion.
Finally, lenders should review a borrower’s federal tax returns to gauge the borrower’s ongoing income. Line 37, Adjusted Gross Income (AGI) shows the borrower’s taxable income. But taxable income is different from actual income in that there are non-cash items, such as depreciation, that make relying on AGI incomplete. The borrower may have sold assets with the sales proceeds included in income. This income is not recurring and should be discounted. A lender needs to have a general understanding of tax returns and how they are prepared in order to reliably determine a borrower’s income.
Conclusion
In project finance lending, a lender needs to thoroughly analyze and understand the three sources of debt repayment; 1) cash flow generated by the subject property, 2) liquidation value of the subject property and 3) the borrower’s secondary financial support. A prudent lender establishes underwriting policies and procedures in accordance with its risk tolerance. In practice, local institutions that are familiar with the local market tend to have more broadly written underwriting policies and rely on their intimate knowledge of the market. Institutions that are not as close to the market, such as large institutions that lend nationwide, tend to have detailed underwriting policies and quickly reject any credit request that does not “fit in the box.” Institutions must develop credit policies and procedures that reflect their risk tolerances and lending practices.
