Scotsman Guide - July 2012 Commercial Edition

Developing a solid understanding of various underwriting processes is critical for commercial mortgage brokers who put their reputation, income and time on the line when they submit client transactions to lenders. A mortgage broker often only gets one shot with a borrower, and if a lender sends the client down a long path of underwriting and loan processing only to result in a declined loan, this client likely will be lost for good.

If the process goes without complication and the loan is closed, however, this will reinforce the broker’s position as a knowledgeable consultant and strengthen the client relationship, which means not only a closed loan, but also a potential source of referrals.

Keep these five commonly missed under writing points in mind as you package deals for lenders.

1. Personal needs The calculation of personal needs — sometimes referred to as the owner’s draw account — is one of the points that significantly vary from one lender to the next. Personal needs are the amount an underwriter allocates for the borrower’s personal expenses, or the amount of income considered enough for the borrower to live on.

“Understanding how the lender calculates personal needs is critical, especially on loans that have low cash flow.”

To determine this amount, lenders typically review the borrower’s credit report and personal financial statement. Then they add a margin to this amount to cover costs that are not listed on the credit report, like entertainment, food, fuel, etc. The margin lenders use is a reflection of how aggressive they are at funding deals — the lower the margin, the more aggressive the funding.

Banks and lenders determine the margin
on personal needs in different ways. Larger
regional or national lenders often have a
set formula like doubling the amount on
the borrower’s credit report — this is con-
sidered conservative. Others may use a 50
percent margin or a fixed amount (such as
$500 per individual in the household per
month). In addition, many lenders will add
some margin for taxes.

2. Double accounting

In this context, double accounting refers to expenses that are reported more than once and thus inaccurately reduce the cash flow. Common examples include debts that are reported on the borrower’s personal credit reports and in the business financials, as well. These debts can be equipment or truck loans, business credit cards, lines of credit, etc. Even if these debts typically are in the company’s name, they commonly are reported on the borrower’s personal credit report, as well.

If a loan officer or a mortgage broker fails to catch this duplication and leaves the payments on the personal needs of the borrower, this could reduce the cash flow tremendously. As a result, the loan could be declined erroneously.

3. Holdbacks on investments Commercial mortgage brokers and borrowers alike often make the mistake of not factoring in underwriting holdbacks into their cash-flow analysis on investment-property loans. These percentages should be calculated off the gross rent and subtracted out as an expense. Typical holdbacks include:

• Market vacancy that commonly ranges between 3 percent and 12 percent or more

• Management fees that are between

2 percent and 5 percent

• interest reserves that are between

2 percent and 4 percent
When dealing with holdbacks, there are
several common questions clients ask,
and commercial mortgage brokers should
be prepared to answer them. These
continued on page 33 »

Jeff Rauth is vice president of SB Capital, a nationwide direct lender for loan amounts as much as $13 million. SB Capital is an approved direct lender of the Small Business Administration Preferred Lender Program (PLP). With more than 14 years of experience in the commercial real estate business, Rauth has worked at two commercial banks and as a commercial mortgage broker. Reach him at (248) 885-8797 or jrauth@sbcapital.com.

personal needs
(The borrower has $45,000 per year of minimum
monthly payments on the credit report)

Table 1: personal needs at 50% margin

Gross revenue $390,154 Cost of goods sold $90,421

Gross profit $299,733

Expenses $195,134 Net profit $104,599 add-backs

Rent being replaced Salary add-back

personal needs

Total cash flow available for debt service Debt service

debt-service-coverage ratio

$55,000

$60,000

$67,500

$152,099

$111,928

1.36
Table 2: personal needs doubled

Gross revenue $390,154

Cost of goods sold $90,421 Gross profit $299,733

Expenses $195,134 Net profit $104,599

add-backs

Rent being replaced Salary add-back

personal needs

Total cash flow available for debt service Debt service

debt-service-coverage ratio

$55,000 $60,000 $90,000 $129,599 $111,928

1.16

holdbacks on
investment property
($546,000 loan amount, 5.5% rate, 20-year amortization schedule)

Table 3: without holdbacks

Total rents (gross income) $80,323
Vacancy holdback 0% $0
Adjusted gross income $80,323
Expenses:
Taxes
Water & sewer rents
Insurance
Legal/other
Utilities
Management holdback 0%