Session 07 Real Estate Finance Underwriting-Rev

TOPICS COVERED THIS SESSIONIntroduction/Types of loansWho does what in the underwriting process.Determining the amount and conditions of T.o.loansInterim Loan determinations made by the underwriter.INTRODUCTIONA. Underwriting is usually done by the loan originator.B. Underwriting is the process of determining the amount and terms of a loanbeing applied for by a borrower.C. Loan originator must make determinations about:1. Economic viability of the project.2. Technical feasibility of the project.3. Legality of the project.4. Viability of the borrowing entity.5. Availability of funding.D. Types of Loans1. Interim Loansa. Short Term (less than 36 months)b. Variable interest ratec. Interim lender takes Completion and Marketing risk2. Take-Out Loansa. Long Term (5-30 years)b. Amortizing (typically with a fixed interest rate)c. Take-Out lender has an interest rate risk3. Bridge Loansa. Great deal of variation in terms.b. “Bridges” from one point in time to anotherc. Loans made against the credit of the borrower not the security of thedevelopment project.4. Mezzanine Loansa. Similar to a Bridge loan but at a time when there is already debtsecured by the development projectb. Subordinate to an Interim or Take-Out loanc. Terms are combination of interest and equity participationSee Loan Timing GraphicWHO DOES WHATA. If the Loan Originator is a lender, underwriting is done by an:1. Interim lender such as a:a. Commercial bank.b. Community bank.c. Mortgage banker.2. Combined interim/bridge/mezzanine lender such as:a. REITb. Insurance/Pension firm.c. Governmental program.B. If the loan originator is a broker, the underwriting is usually done in stages.1. An initial underwriting is done by the broker to determine the type offunding institution to approach with a request for a loan.2. Once a funding institution has been identified the initial underwritingwill be adjusted.a. Usually the contact with the borrower is maintained by the broker.i.Because the broker only gets a fee if the loan closes.ii. Because the broker is familiar with the details of the type and location of the applicantant’s project.b. To reflect the underwriting standards and policies of the fundinginstitution.DETERMINING THE AMOUNT AND CONDITIONS OF LOANSA. The amount of the T.O. Loan is determined by the lesser of:1. A percentage of the appraised value.a. 65-70% of appraised value for commercial.]b. 75-85% of appraised value for residential.2. The amount of take out debt that the projected income stream can support.a. Calculate the Net Operating Incomei.Gross Rent Roll (potential) = net rentable space multiplied by theunit rent per year.ii. Less vacancy and credit losses = an arbitrary factor usuallydetermined by the underwriter to reflect the amount of space that isvacant during some portion of the year or rent that cannot becollected from tenants.iii. Less operating expenses = expenses paid by the owner (borrower) to provide and maintain space per year.iv. Equals Net Operating Income per year.b. Determine a Debt Service Cover Ratioi.Amount of annual reserves the lender will estimate in case all otherprojections prove to be optimistic.ii. Arbitrary figure which ranges from 1.15 for an extremelyaggressive loan to 1.40 for an extremely conservative loan.iii. In good times, DSCR typically ranges between 1.10 and 1.25c. Divide the NOI by the DSCR which results in the estimation of theamount available to service debt per year.d. Determine an appropriate Annual Loan Constant. (debt constant ormortgage constant)i.The Loan Constant is a function of the interest rate, paymentperiod (compounding period), and term of the loan (number ofpayment periods)ii. Loan Constants are determined by the underwriter based on the yield objectives of the Take-Out lender.(note that yield can bechanged by changing the discount or points)iii. Values of constants can be found in Tablesiv. Perhaps the best way is to use a financial calculation on acalculator or computer to compute a loan constant., AND TERM OF THE LOAN WITH THE TIME FRAME OF THE ANALYSISIT IS CRITICAL TO MATCH THE INTEREST RATE, PERIODIC PERIODe. Determine the amount of the Take-Out loan by dividing the AmountAvailable to Service Debt by the Loan Constant.B. The amount of the Interim Loan is determined by the lesser of:1. The estimated amount of the Take-Out loan2. A percentage of the Total Project Costa. Calculate Total Project Costs (Note this is a different amount from theAppraisers Replacement Cost because it does not include Profit.)i. The cost of landii.The cost of constructioniii.The Cost of Services and Fees (don’t forget to include Washington State Sales Tax on Construction cost – WSST)iv. The cost of Financingv. A Contingencyb. Multiply Total Project Costs by a Loan to Cost Ratioi. This is an arbitrary factor supplied by the Interim lenderii.In good times it might be as high as 90% (maybe even 95%)iii. Today it is probably in 65%-75% rangeTHIS FACTOR GUARANTEES THE BORROWER HAS CAPITAL AT RISK DURING THE TERM OF THE INTERIM LOANB. Terms are set by the underwriter based on:1. The length of the construction loan.2. The variable interest rate.a. Historically based on Prime Rate of Lendingb. Currently more often based on other indexesi.U.S. Treasury rates for a similar termii. LIBOR (London Interbank Overnight Rate)c. Plus an appropriate risk premium.i. Risk premiums depend on the underwriter’s assessment of projectand borrower riskii.What the “market will bear” (Competition)3. The type and amount of security.a. Note which is a promise to repay.i. Nonrecourse which requires no personal liability.ii. Recourse which gives lender access to other assets owned by the borrower or guarantor.b. The real estate project itself.i.Mortgageii. Deed of Trust.TERMS OF INTERIM LOAN COMMITMENTS ARE BASED ON THE UNDERWRITING CALCULATIONS.A. D etermining the economic viability of the project.1. Underwriters verify appraisal data.a. Project location must be checked in person or through independentconsultants.b. Check projections for NOI.i.Reasonableness of rentsii.Lender’s experience with vacanciesiii. Operating expense projections.c. Comparability of project sales data.Bottom line is "would the underwriter be willing to own and operate the projectfor the amount of the loan?"2. Verification of project costs.a. Land is a favorite place to hide costs that would otherwise not beacceptable, and underwriters must be aware of comparable land costs.b. Construction costs are often checked independently against previousexperience of the lender or with a contractor.c. Services and fees are often dealt with by underwriters givingborrowers allowances which cannot be exceeded.d. Financing costs are negotiated between borrowers and eitheroriginators or underwriters as representatives of the lender.e. Contingencies are most often negotiated.i. Used to cover all unforeseen costs.ii. Lender will often attempt to reserve contingencies for overruns in interest rather than release funds for things like constructioncontingencies. (Contractors beware)3. Underwriters must make an overall judgment about the general conditionof the market for development projects like the one being proposed.a. This is an area that is difficult to do at best.b. When underwriting is being done by a broker there is a strongtendency to push for a feasible determination even in the face of a"bad" market. (No deal = no fee).B. Determining the technical feasibility of project.1. Evaluate the architect/engineer/contractor teama. General reputation and previous experience.b. Special expertise required on given project.i.Specialized use such as shopping centers.ii. Special site conditions such as soils.c. Financial strength - particularly of contractor.2. Verify approvals to ensure that they have been given.a. Usually require that the borrower assume this responsibility underpenalty of withdrawing the loan if approvals are not legally obtained.b. Environmental clearances, zoning, and building permits will all berequired before closing of an interim loan.3. Verify condition of title.a. Title is insured by a Title Insurance Company subject to acceptableexceptions.i.Liensii. Easementsiii. Encumberances -Covered under Session on Titles.b. Underwriter must accept the condition of title or request the borrowerto remove specific exceptions.C. Determining Viability of the borrower.1. Legal form and authority of the borrowing entity.a. Form determines extent of personal liability for repayment ofconstruction loani.Individual or partnership allows personal liabilityii. Corporate form does not.b. Determine who has legal authority to commit the borrower to terms ofthe loan.2. Credit worthiness of the borrower.a. Who are individuals involved and what has been their experience withsimilar types of projects.b. Determine net worth requirements.i.Types of assets available to borrowers, particularly the degree ofsafety, liquidity, and market risk.ii. Types of borrowers liabilities and their relationship to assets pledged as security.c. Amount of borrowers income and earning capacity.E. Determining the availability of funding.1. Fit with business plan and policies of funding institutionsa. Type of project and its location.b. Size of the requested loan.c. Type of borrower ;i.The previous experience with similar projects and borrowers.ii. Borrowers liability/ownership in project - amount of equityinvested in the project.2. Availability and flexibility of participants and funding institutions for theinterim loan.a. The degree to which other sources of funds are available to share therisk.b. The degree of previous experience and confidence underwriters havein potential participants.3. Evaluation of risk/rewards.a. Other loans that can be made compared to this loan.b. Other investments (stocks, bonds) that can be made.c. Other borrowers available to lend to.d. Gut hunch about the deal, the borrower, the market.4. The availability of Take-Out commitments acceptable to the borrower.a. The form of the commitment - Covered under session on Take-OutCommitments.b. The terms of any existing commitment.c. A loan without a take out commitment is called a naked or uncoveredinterim loan.FOR THE LAST 30 YEARS ALL INTERIM LOANS HAVE BEEN “NAKED”TOPICS COVERED THIS SESSIONIntroduction/Types of loansWho does what in the underwriting process.Determining the amount and conditions of T.o.loansInterim Loan determinations made by the underwriter.。