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How to Underwrite Commercial Real Estate: A Beginner's Guide

Want to know how to underwrite real estate? Here's a quick primer on what lenders consider before approving a commercial real estate loan.

[Updated: Mar 03, 2021 ] Jan 29, 2020 by Erik Martin
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You're excited about a commercial real estate property, but you need a real estate loan. If you're involved in real estate investing, it's a good idea to understand how to underwrite real estate. Getting this loan approved won't be easy. That's because the lender's underwriter will carefully review your creditworthiness. They scrutinize things like the borrower's credit history, debt service coverage ratio, net operating income, effective gross income, and more. To get you up to speed, let's cover the basics you need to know about underwriting real estate, including:

  • What is underwriting?
  • Role and goal of the underwriter.
  • Real estate investing from the lender's perspective.
  • How to improve your loan approval odds.

What is underwriting?

The process of underwriting is crucial for the lender of a commercial real estate loan. That's because underwriting reveals the truth about you as a loan applicant and about the property you're seeking to invest in.

Underwriting evaluates your honesty and creditworthiness as a borrower. And it helps the lender determine the level of risk involved in providing funds for the property. It's the lender's way of performing their necessary due diligence -- of doing its homework on the applicant.

Role and goal of the underwriter

There are plenty of people involved in the lender's team. One key player is the underwriter. This professional is the one responsible for making sure that the borrower meets all the requirements and guidelines for the loan. He or she will also evaluate the risks involved with a given loan. The underwriter ultimately determines whether the loan is accepted or rejected, too. To better understand how to underwrite real estate, let's take a closer look at what the underwriter does.

Real estate underwriting steps

Underwriters pore through the loan application and accompanying documents, checking all the math carefully. This is an essential job because they're the ones responsible for ensuring that applicants can repay what they borrow.

The underwriter has to keep track of a lot of paperwork. This person also has to perform careful calculations and ask key questions. They seek answers to the two most important questions of all:

  1. Is this borrower a good candidate we can trust to fulfill the loan obligations?
  2. Is this property a worthy lending investment?

To answer these and other questions, the underwriter will check several things, including your:

In addition, the underwriter will request an appraisal of your property to determine its market value. The underwriter will also conduct a title search to see if anyone else is on the title. And they'll ensure that the property's location isn't vulnerable to floods, fires, or other natural disasters.

Real estate investing from the lender's perspective

The underwriter will evaluate the property's potential as a real estate investment, too. Ideally, the commercial real estate property you're seeking a loan for has healthy effective gross income and the capacity for increased value or expansion.

Also, the more experience you have as an investor -- particularly in the same commercial real estate sector you're seeking funding for -- the better your odds of getting the loan.

A previous bankruptcy or foreclosure may hurt your chances. If you have one on your record, prepare to explain the circumstances behind this event and demonstrate why you're a good borrower prospect.

Determining property viability

There are several other significant criteria the lender will consider from the lender's perspective in its real estate underwriting. One of these is the debt service coverage ratio (DSCR). This ratio reveals your property's capability of repaying any debt service via its net operating income (NOI). Lenders value the DSCR highly, as a favorable number assures them that the property can generate the needed cash flow to pay back the loan on time. Lenders typically prefer a DSCR higher than 1.25x or 1.5x. A DSCR below 1.0x indicates that the property's yearly income isn't sufficient to repay the debt.

How net operating income is determined

To help calculate the NOI accurately, you'll likely be asked to provide a proforma and rent roll. Note, however, that the lender may create its own proforma. The underwriter may also tweak the NOI by factoring in uncertainties like the potential for high tenant turnover and unfavorable market circumstances.

Understanding loan-to-value ratio

Another valuable metric your lender will use is the loan-to-value ratio (LTV). This tells you the size of your loan compared to the value of your property. LTV is calculated by simply dividing the amount of the loan into your property's value. Say the amount you're seeking for your commercial real estate property is $500,000. Assume the appraised value of that property is $750,000. In this case, the LTV ratio would be approximately 67%. The lower your LTV, the better your chances of the loan being approved. Many commercial mortgage lenders prefer an LTV between 65 and 85%.

Next comes the maximum loan analysis

Your lender will use the DSCR, NOI, and LTV numbers to create a maximum loan analysis. This analysis suggests the ceiling on a supportable loan amount. They determine this maximum lendable amount by taking the smaller of the two loan amounts established by the DSCR and LTV.

How to improve your loan approval odds

Worried that the lender may turn down your commercial real estate property loan? You can increase your chances of getting approved by following these tips:

  • Give the lender everything they ask for: Complete the loan application fully, provide all requested documentation, and answer any questions or requests the lender has punctually and thoroughly.
  • Consider having the property appraised prior to applying for the loan. Hire a professional to appraise the commercial property. Attaching this report to your application can impress the lender and may speed up the approval process.
  • Demonstrate the property's future potential by mentioning growth and development possibilities in your loan application. For example, indicate to what extent you intend to raise rents in the near future. Cover your plans for a building renovation coming soon. Provide details on your newly hired property management company and how they will increase maintenance efficiency.
  • Clarify your strategies and goals as a real estate investor. Explain in your application and when meeting face to face with the lender your philosophies as an investor. Make a case for why this property is a good investment and why you are a worthy borrower.

In summary

Knowing how to underwrite real estate can make a big difference to you as an investor. Understanding what's involved with underwriting and what the lender considers carefully can position you as a more deserving borrower. You can better complete a loan application and provide exactly what the lender requests -- and knowing the factors and processes involved ahead of time can give you increased peace of mind throughout the process.

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