How to Underwrite Commercial Loans

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Underwriters perform due diligence on loans for commercial projects, such as shopping malls.
Underwriters perform due diligence on loans for commercial projects, such as shopping malls. (Image: Jupiterimages/Comstock/Getty Images)

Underwriting is the process a commercial mortgage application undergoes in which creditworthiness, income, property valuation, business revenue and property soundness are all verified by an expert. This process is almost exclusively handled by a third party separate from the loan officer so the review remains unbiased, fair and accurate.

Verify the cash flow of the business. This is the most crucial component of the underwriting process, as it confirms the borrower's ability to repay the loan. Use the debt coverage ratio, or DCR, to verify proper coverage. Look for a ratio of at least 1.20. This means that the borrower must prove at least $1.20 in business income for every $1 of commercial debt outstanding. The formula for DCR is: DCR = cash flow from total operation / total outstanding debt. For example, if you're receiving $400,000 in revenue each month and your total debt is $325,000, your DCR is 1.23 -- an acceptable ratio for lending.

Determine the borrower's creditworthiness. Commercial underwriting is different from residential or personal underwriting in that you must determine both the business's creditworthiness and the business owner's creditworthiness. Pull credit reports (tri-bureau reports are best -- Experian, Equifax and TransUnion) on the borrower, and review all previous commercial loans with the business itself for payment history. Delinquent accounts on any report are red flags.

Verify a commercial loan's loan to value ratio, or LTV. This stands for the amount of debt outstanding on a property versus the value of the property. Review the appraisal(s) for accuracy and fairness. Special attention should be given to the comparable properties used for valuation. Adjust the market value if warranted. Based on the principal loan amount, calculate the LTV. This equation is expressed as: loan amount / market value. (e.g., a $500,000 loan on a property worth $1.5 million creates an LTV of 33 percent)

Scrutinize the property report. This document or set of documents confirms the age of the structure, any major repairs needed, the condition of the foundation and any recommendations for adjustments to the structure. Make sure if a report claims a property is structurally sound, it is actually true. Things to watch out for: cracked foundations, leaky roofs, rotten wood and old plumbing.

Grant approval or grant pre-approval with conditions on the loan only when you have comfortably verified all of the elements listed above. If a loan defaults, often the underwriter is the first to be reprimanded.

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