Commercial Mortgages 101

Everything You Need to Know to Create a Winning Loan Request Package

 Commercial Mortgages 101

Author: Michael Reinhard
Pub Date: May 2010
Print Edition: $21.95
Print ISBN: 9780814415078
Page Count: 240
Format: Paper or Softback
e-Book ISBN: 9780814415085

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Excerpt

INTRODUCTION

Commercial Mortgages 101 is the culmination of fifteen years’

experience in commercial real estate lending and credit analysis

that began at the conclusion of the savings and loan crisis

of the late 1980s and early 1990s. Toward the end of the savings

and loan crisis that dominated the headlines for nearly a

decade, commercial real estate lending was virtually nonexistent.

Lending practices and underwriting policies once thought

sound were now deemed completely unreliable. Eventually, a

new breed of lenders rose from the ashes and reestablished the

commercial real estate lending industry, transforming and setting

in place new underwriting and credit standards still relevant

today. Commercial Mortgages 101 embodies this new establishment

and attempts to provide a comprehensive overview of

commercial real estate loans and fundamentals in underwriting

and credit analysis. But before we discuss the contents

within this book, a little history is in order.

The Tax Reform Act of 1986 and ensuing savings and loan

crisis set in motion the beginning of the end for commercial

real estate loans. Commercial real estate lenders were about to

enter the Dark Ages, a decade-long systematic collapse and

decline of the commercial real estate loan industry. From 1986 to

1995, the number of federally insured savings and loan institutions

in the United States declined from 3,234 to 1,645. This was primarily

but not exclusively a result of unsound commercial real estate

lending. While they were not part of the savings and loan crisis,

many other commercial banks failed during this time, as well.

Between 1980 and 1994, more than 1,600 banks insured by the

Federal Deposit Insurance Corporation (FDIC) were closed or

received FDIC financial assistance. The U.S. government ultimately

appropriated $105 billion to resolve the crisis. After banks repaid

the loans through various government interventions, there was a

net loss to taxpayers of approximately $124 billion by the end of

1999.

Although the savings and loan crisis of the 1980s and early

1990s seemed to have singlehandedly brought the commercial real

estate lending industry to a halt, there were a few commercial banks

and nonbank lenders such as life insurance companies and pension

fund advisors that were still making commercial real estate loans,

primarily refinances. But it wasn’t until about 1993 that a new breed

of commercial real estate lenders called conduit lenders emerged as

a new source of commercial real estate loans, marking the beginning

of a new era and forever changing the way commercial real

estate loans are originated and underwritten. Conduit lenders,

which were created by Wall Street investment banks, reignited the

commercial real estate loan industry by providing a secondary market

(called securitization) for mortgage banking firms, commercial

banks, life insurance companies, and federal savings banks (successors

of the savings and loan banks), a market that had never before

existed. The commercial real estate lending industry, unlike years

before, was now back in business.

With the advent of conduit lending or securitization came a new

way of underwriting that was sorely absent during the era of the savings

and loan turmoil. Stringent underwriting ratios and guidelines

set by Wall Street investment banks during this time became the

new standard for making commercial real estate loans among traditional

banks or any other lender entering the mortgage banking

business. Sound underwriting practices didn’t just stop with the

Wall Street banks; credit rating agencies such as Standard & Poor’s,

Fitch, and Moody’s also provided further scrutiny before a loan was

securitized. The adoption of this new underwriting standard by traditional

banks and other nonconduit lenders has duly been cemented

in the industry and now serves as the basis for understanding

how commercial real estate loans are underwritten.

The commercial real estate loan industry is very complex and

widely misunderstood by the average person. Even seasoned commercial

real estate developers who borrow tens of millions

of dollars fail to appreciate the difficulty in procuring a real

estate loan. This fact is evident every time they are forced to solicit

help from a commercial mortgage brokerage firm after months of

unsuccessful attempts of their own. No matter who loans the money

for the development, purchase, or refinance of a commercial property,

whether it is a small-town building and loan institution like the one

in the movie It’s a Wonderful Life or a complicated consortium of private

equity sponsored by a largeWall Street investment bank, the fundamentals

of commercial real estate loans and underwriting remain

the same. Therefore, the intent of this book is not to try to explain the

intricacies and inner workings of today’s complex real estate capital

markets but to explain these fundamentals in a way that teaches the

reader how to effectively think like a commercial real estate lender.

The book has three primary objectives. The first is to introduce

the reader to the basics and fundamentals of commercial real estate

loans. The second is to illustrate how both a borrower and a com-

mercial real estate loan is underwritten and the third and most practical

objective is to explain how to successfully prepare a comprehensive

loan request package. This book is designed to appeal to a

wide array of readers, including residential mortgage brokers, entrylevel

commercial mortgage brokers, novice real estate investors, college

and university students, real estate instructors, and promoters

and educators of real estate investment clubs and seminars, just to

name a few.

The idea for this book came from years of dealing with novice

real estate investors and residential mortgage broker clients in

search of their very first commercial real estate loan. Typically, the

average seasoned commercial real estate loan officer is solicited by

professional commercial mortgage brokerage firms or institutional

borrowers that employ teams of experts. Often these professionals

prepare lengthy and comprehensive loan request packages (similar

to a business plan) for the lender’s review and approval. The purpose

of the loan request package is to put everything at the lender’s

fingertips in a well-organized and persuasive prospectus for easy

reference. Deviating from this method of loan solicitation only frustrates

the lender and results in a game of phone tag between the

lender and the broker in search of unanswered questions resulting

from an incomplete package. Experience has shown that first-time

commercial loan applicants, whether they are beginners or residential

mortgage brokers seeking loans for themselves or for a client,

often do deviate from this method. Many times they are inexperienced

and unprepared to deal with the barrage of questions asked

by the lender. Often a lender will simply reply to the broker’s or

investor’s loan solicitation with a request of her own: “Well, just

send me your loan request package, and I’ll take a look at it.”

In order to prepare a comprehensive loan request package, one

must be knowledgeable in the field of commercial real estate loans.

Preparing and creating a loan request package is often left to the

professionals, but if the borrower doesn’t have a basic knowledge of

commercial real estate loans and of the fundamentals of underwriting

and credit analysis, he may find that creating a loan request

package can be a daunting task. Though there are many books and

schools that offer various courses in commercial real estate, there

are none that combine an overview of commercial real estate

finance, loans, and underwriting with real-world practical applications.

Most real estate finance books are too technical or academic

for the average real estate investor, leaving the reader intimidated

rather than empowered. This book, however, is written in a conversational

manner, as if someone were speaking to an audience for the

first time with the specific goal of making them feel at ease or comfortable.

The aim of the book is not only to educate the reader but to

provide a step-by-step instruction manual for residential or entrylevel

mortgage brokers and real estate investors in search of their

very first commercial real estate loan.

The book is divided into six chapters. Chapter 1 is primarily

intended to provide the reader with an introduction to commercial

real estate loans and underwriting. Chapter 1 is written with the

beginner in mind, someone who is presumed to have no prior

knowledge of or experience with commercial real estate or commercial

real estate loans. The chapter begins by defining and

explaining the word “mortgage” as it relates to the commercial real

estate industry. (We also define the word “commercial.”) This discussion

is followed by a description and analysis of the different

types of commercial properties. Midway through the chapter, the

reader is introduced to the different types of commercial real estate

lenders that originate and fund commercial real estate loans and

mortgages. The reader is also introduced to common industry terms

associated with a commercial mortgage such as “loan-to-value” and

“amortization.” The chapter concludes with an overview of the

basics of commercial mortgage underwriting that are universal to

all commercial real estate loans. Prior to reading Chapter 1, the

reader is likely to have had some exposure to or experience with

commercial real estate or commercial real estate loans during his

career. For readers who have no experience with commercial real

estate loans, Chapter 1 is a must-read, but for those with some level

of experience, it should serve well as a refresher course. However,

no matter what level of experience the reader may have had with

commercial real estate loans, I highly recommend a review of

Chapter 1 before moving on to Chapter 2.

After reading Chapter 1, the reader should be sufficiently well

versed in the basics of commercial real estate loans and underwriting

to start searching for his first commercial real estate loan. But

before the search can begin, he must prepare a loan request package.

By now you may be asking yourself what in the world is a loan

request package and how is it prepared. Well, Chapter 2 answers

that question and even walks you through the process step by step.

For anyone who already has some experience in commercial real

estate and who desires to break into the commercial mortgage brokerage

business, Chapter 2 is the place to start.

We anticipate that many readers may be already in the process

of searching for or attempting to broker a commercial real estate

loan without a loan request package. Without a professional and

well-prepared loan request package, you risk losing the lender’s

interest and may come across as extremely inexperienced, as well.

The loan request package is very similar to a business plan and

should always be used to make a good first impression with any

lender.

Loan request packages are essential to any mortgage broker’s or

real estate investor’s success. Length and quality of loan request

packages vary, depending on the complexity of the real estate

transaction. Unfortunately, they are often hastily prepared, rudimentary,

and poorly written. No two loan request packages are alike, and not

all of the information suggested or recommended in Chapter 2 is

necessary in every case. Loan request packages can be as short as

five pages or as long as forty pages. A professional and persuasive

loan request package, one that is mostly likely to retain a lender’s

interest, has six sections: the executive summary, property description,

location and demographics, economics, submarket data, and

sponsorship. The sponsorship section of the loan request package

as described in Chapter 2 is no more than a two- to three-page summary

describing the borrower’s net worth, liquidity, ownership

experience, and real estate assets. Though words like “net worth”

and “liquidity” may sound familiar, not everyone fully understands

how they are calculated or used in underwriting. Because attributes

such as these embody the essence of underwriting as a whole, we

expand our discussion within a three-chapter section that begins

with Chapter 3.

In general, the measure of financial strength and creditworthiness

is based on a variety of factors that are not easily understood.

It is often said that a person’s net worth exists only on paper or that

the person is house-poor or cash-poor. Adding to the confusion is

the concept of liquidity. What does all this mean, and why does the

lender need to know? All these issues and more are discussed in

Chapter 3; the chapter looks at such topics as credit history, credit

scores, personal cash flow, and banking and credit references. Even

if a borrower passes the credit test, financial wherewithal alone is

not enough to secure a loan. In addition to having a high net worth

and an acceptable credit score, the borrower must have extensive

experience in owning and operating commercial properties. The

level of experience of any borrower is extremely important and cannot

be overemphasized. Lenders in general are skeptical by nature

and need quite a bit of convincing before they will make any kind of

commitment to the borrower. So how can a lender be persuaded?

Chapter 4 attempts to answer that question and also explores the

way would-be borrowers can demonstrate ownership and management

experience.

If, in fact, a borrower has extensive experience in owning

and operating commercial real estate, it is reasonable to assume that

a majority of the borrower’s assets will be vested in real estate.

Nothing persuades a lender more than an impressive portfolio of

commercial income-producing properties. Generally speaking, net

worth is derived primarily from the equity vested in a variety of

assets, including cash, retirement accounts, personal property, business

assets, and real estate; however, it’s the real estate assets that

are of most interest to the lender. The description and the market

value of real estate assets listed on the assets side of the balance

sheet are often just a sum total of a separate real estate schedule that

provides greater details. This separate schedule or supplement to

the balance sheet is referred to as the Schedule of Real Estate

Owned or REO Schedule. What is a real estate schedule, and why is

it so important? The answer to these questions and more, including

a sample REO Schedule, can be found in Chapter 5, concluding our

three-chapter series devoted to a borrower’s financial strength, creditworthiness,

and experience.

Another area of confusion and misconception in commercial

real estate investing and lending relates to the different forms of

ownership. Even though buying and investing in commercial real

estate in one’s personal name is less expensive and complicated

than vesting title in a separate legal entity, both lawyers

and accountants alike always advise against it. Purchasing and owning

commercial real estate within legal entities such as

limited liability companies and corporations is usually preferred

over individual ownership. Whether for tax reasons or to

minimize liability, certain forms of ownership are more likely than

others to create complications for borrower and lender. Brokers and

individual real estate investors often under-estimate the importance

of legal ownership structures and the impact they have in shaping

the loan. Chapter 6 addresses this issue head-on by first explaining

the difference between a borrower and a borrowing entity and then

offering an overview of nine different forms of ownership, presented

in layman’s terms.

The book overall is specifically written for the beginner whose

knowledge of commercial real estate loans is limited. Underwriting

commercial real estate loans is more art than science and is mastered

only through years of back-office experience. The discipline of

commercial real estate loan underwriting is further complicated by

the fact that not every lender underwrites a loan exactly the same

way. It would be unrealistic to assume that every type of property

and every type of loan could be covered in just one book.

Nevertheless, the fundamentals and the universal practice of commercial

under-writing and credit analysis for any commercial real

estate loan are common to just about every lender. The book is not

intended to teach the reader how to be a financial analyst or

a commercial underwriter overnight; it is more a user’s manual to

help those dealing with commercial real estate loans. Also, the book

does not necessarily have to be read from cover to cover but can be

referenced over time. Whether the book is read in its entirety or in

part, the overall goal is to enhance the reader’s skills in credit analysis,

commercial underwriting, and loan solicitation. Whether you

are a residential mortgage broker looking to break into the commercial

mortgage brokerage business or a beginner real estate

investor looking to transition from small residential properties to

large commercial pro-perties, learning how to think and speak like

a commercial real estate lender will put you on an even playing field

with the professionals.

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