Understanding the subtle nuances in commercial real estate underwriting can help CRE lenders unlock profitable deals and safeguard your interests.
With over $20.7 trillion in commercial real estate, it’s clear that underwriting is vital in today’s market. But what exactly does it involve? Let’s take a look!
In commercial loan underwriting, lenders evaluate a loan application and determine whether to approve or deny it. The process evaluates borrowers’ creditworthiness and risk profile to assess whether they can repay the loan.
When it comes to commercial real estate, underwriting involves scrutinizing more than just an individual’s credit score. It considers multiple factors like property appraisal, property financial performance, and income verification documents.
Underwriting in commercial real estate also entails conducting due diligence on the property itself. Lenders will thoroughly inspect interior and exterior components, ensuring that all safety regulations are met, and no structural issues are present.
What Is Commercial Real Estate Underwriting?
Commercial real estate underwriting involves analyzing and assessing a property’s future cash flow potential and ability to generate income.
Underwriters consider various factors, such as rental rates, tenant creditworthiness, current market conditions, and local trends. Their ultimate goal? Minimizing risk on the loan.
What Does a Commercial Real Estate Underwriter Do?
A real estate underwriter plays a major role in determining the risk involved in approving or denying the real estate loan for the borrower. It’s their job to review all financial documentation provided by the borrower and analyze any potential risk factors associated with the investment.
They also order a property appraisal and credit report to analyze the creditworthiness and the property’s net value. They look at the following:
- Property type
- Value of the property
- Vacancy rate
- Borrower’s credit score
- Credit history
- Net worth
- Bank statements
- Cash flow statements
The underwriter then uses this information to recommend approving or denying the loan. Their thorough research helps to ensure that borrowers can get loans with favorable terms that best fit their needs safely and securely.
How Does Commercial Real Estate Underwriting Work?
In real estate underwriting, lenders and underwriters will look at the current market conditions to decide if a real estate property investment is a good fit. They’ll look at the local economy, job growth, population trends, supply and demand for housing, etc.
They will also consider the financials of the project or property being underwritten. This includes cash flow projections, sale price, proforma data, closing costs, occupancy rate assumptions or trends, construction costs and timelines, and capital requirements.
They may also need to analyze environmental factors such as zoning regulations, exposure to natural disasters, or potential environmental risks like seismic activity or flood zones. If any information doesn’t align with expectations, additional research may be needed before proceeding with the opportunity.
The underwriting process for existing buildings versus developments is different in multiple ways.
When underwriting an existing building, you can assess its current performance and better estimate how it will operate under new ownership. This includes analyzing the current lease expirations, renewal probabilities, market rents, tenant improvements, leasing commissions, and downtime associated with renewing or releasing tenants.
However, you must include additional elements for development projects because of the necessary construction period. This includes pre-leasing costs and efforts and budgeting for any timeline miscalculations that could occur during the build-out period.
Developments also require more upfront capital due to the costs associated with acquiring land and beginning construction before any income is generated from tenants. There may be uncertainty on how long it will take to lease out all available spaces despite pre-leasing efforts.
All these factors make underwriting a development challenging and more complex than an existing building.
Key Factors Used in CRE Underwriting
When determining the viability of a commercial real estate investment, underwriters will examine several critical elements:
Net Operating Income (NOI): A key factor in underwriting commercial real estate investments, NOI is a measure of income the property will produce in a year after subtracting operating expenses like maintenance fees, property tax, utilities, and CAM fees. To estimate more realistic NOIs, adjustments such as vacancy allowances or bad debt expenses may be made.
Cap Rate: Expressed as a percentage, this metric is used to determine the return on the property. It’s calculated by dividing the annual NOI by the property’s purchase price. Lower cap rates of 3 to 6% show that the purchase is expensive for the borrower. Higher cap rates of 7 to 10% indicate it’s more affordable.
Debt Yield: This measures how much cash flow will cover all loan payments after subtracting a proposed mortgage amount from NOI. Lenders use this ratio to evaluate borrowers’ ability to repay loans and maintain loan covenants over time. Generally, debt yields should be at least 1.15x for most banks. However, some lenders may require higher ratios (upwards of 1.30x).
Debt Service Coverage Ratio (DSCR): This is an important metric when evaluating borrowers’ creditworthiness and ability to repay debts from their cash flows. DSCR compares NOI with total debt service and typically should be above 1.2x; however, some lenders may have stricter requirements depending on loan terms and conditions.
Loan-to-Value Ratio (LTV): This measures the amount of leverage taken out against the value of an asset and helps lenders gauge their risk exposure when making loans secured by commercial real estate properties. Generally, LTVs range between 70% – 80%. However, some lenders will allow up to 90%, depending on the collateral type, location, and other factors related to an individual transaction.
Blooma Can Simplify Your CRE Underwriting Process
At Blooma, we understand that the underwriting process can be time-consuming and daunting for CRE lenders. That is why we are making it simpler and smarter than ever with a platform designed to automate manual process and deliver data-driven insights. With its unique features, Blooma streamlines the entire underwriting process by providing quick access to all the information a lender may need to make informed decisions on the property, while offering several easy options to accelerate the approval process.
Blooma’s easy-to-use tools make it fast and efficient for lenders to review loan applications, assess potential risks, and check market data. It also helps identify potential problems early in the process so lenders can avoid delays and maximize their success rate.
For CRE lenders looking for an easier way to underwrite loans and find real estate opportunities quickly, Blooma could be just what you have been searching for! With its unique platform, you can simplify your underwriting process while helping your clients find the perfect commercial real estate investment.
So why wait? Get your demo now and take your business to the next level!