A return to fundamentals in commercial loan availability and underwriting…

This afternoon, I had lunch with John DiMichele, the CEO of Community Business Bank, a local bank less than 3 years old with nearly $150,000,000 in assets that focuses on relationships with small and medium sized businesses and non-profits in Sacramento, San Joaquin, Placer, Yolo, and Solano counties. John is a veteran of the banking industry and has more than 30 years in banking and has been the CEO at four financial institutions. (So here is the disclaimer, Jim Gray has been on the board of two different banks that John has led – but none the less John D. is a smart guy who we are proud to say is our friend and banker.)

Over lunch John said; “In my career I have never seen it change so quickly. There are still good customers out there and there are still plenty of good loans to be made—but we need to do a much better job of underwriting and we just have to say ‘no’ to some loans that we would have made just a few months ago. We don’t have to say we won’t make commercial loans or that we won’t make construction loans, but we do need to be more cautious and more thorough as we underwrite those loans. We must make sure that we underwrite not only the asset but also the cash flow and secondary sources of repayment.”

John is not alone in making these kinds of observations … Prudent lenders and the market place have tightened up their underwriting standards. Here are some ways that Commercial Real Estate Investors need to think about the implications of better underwriting. (And I do mean better.)

Six months ago you could get a commercial loan with a 75% to 85% Loan to Value Ratio- LTV. Now maximum LTV ratios are more like 65% to 70%. On a $5,000,000 acquisition 6 months ago you could have borrowed $4,250,000. Today you would be fortunate to borrow $3,250,000. In other words, you would need an additional million dollars in down payment for a total of $1,750,000.

The other underwriting ratio is the one that evaluates cash flow and it is known as Debt Coverage Ratio. DSCR . Six months ago you probably could have gotten a loan with a 1.10 or 1.15 DSCR. Now it is probably more like 1.25 to 1.30 DSCR.

The debt service coverage ratio is the ratio of net operating income to debt payments on a piece of investment real estate. It is a benchmark used in the measurement of an income-producing property's ability to produce enough revenue to cover its monthly mortgage payments. The higher this ratio is, the easier it is to borrow money for the property. In general, it is calculated by: DSCR = Net Operating Income / Total Debt Service

To determine the DSCR one needs to determine the Net Operating Income, NOI. In this $5,000,000 property example, let’s assume it was acquired at a 7% Cap rate, = $350,000 NOI. Then let’s assume that one could find a market interest rate of 7% and a 25 year amortization for the $3,250,000 loan balance, that would mean a monthly debt service of $22,837 or $274,045 per year. The DSCR is the annual Net Operating Income divided by the Debt Service which in this case is 1.28. In other words the cash flow after paying expenses and debt service is $75,955. The banker or the investor in the mortgage debt are now comfortable and feels that their risk of default is “covered”. The bank underwriter has returned to “tried and true” underwriting standards. And they have changed quickly.

Finally, let’s now look at the return that the buyer/ property investor receives in a $5 million dollar property with these more conservative underwriting standards. The Investor increases their down payment—investment -- to $1,750,000 and receives $75,955 in annual cash flow after paying expenses and servicing the mortgage debt, that equates to a 4.34% cash on cash return. In addition, after paying 12 monthly payments- interest and principal - there would be $48,069 in principal reduction which is 2.75% additional return on the initial investment.
In this new, more normal, lender /borrower relationship, the bank is “covered” and receives a 7% return on their mortgage debt and the buyer receives a cash flow of 4.34% and a total return including principal reduction of 7.1%.

Clearly what this means to a community banker is there remains a willingness to take a risk so long as it is coupled with a reasonable return for the risk and a requirement that the investor has a sound investment. How can one argue with these fundamentals? A borrower is going to have to have more cash, stronger collateral, and outstanding credit to achieve approval in this return to underwriting fundamentals.