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Poll Finds Direct Payment Improves Credit Scores

National Mortgage Professional
Nov 18, 2001

Commercial Loans: What Works, What Doesn't: Got excellent credit, property, occupancy and income history? Great!--Now prove it!Serafim Ivaskdocumentation, presentation, commercial loan package In residential cases, the success or failure of an application often depends on the accuracy and consistency of the submitted information. It is much the same, and perhaps even more so, with commercial loans, since one can not hide behind some variant of a "No Doc" provision. Either the documentation (read: proof!) is there or it is not. Income qualification processes itself because commercial loans are very straightforward. All we need to do is provide sufficient, accurate and consistent evidence to support the income and expenses. The borrower and the property may then be eligible for competitive, long-term, fixed-rate programs such as those offered through Wall Street conduits or life or major credit companies. If the information is not credible or is missing, there may still be other short-term financing alternatives available to the borrower, until supporting acceptable documentation is presented to qualify the deal for a loan on more favorable terms. In this month's article, I will concentrate on the form and substance of the documentation that you will need for most of your cases seeking permanent financing. For the balance of this article, pretend that you are the lender. It is your money that will be at risk once you lend it. Your primary goal is to make money on your money, not to lose it or squander more money getting it back from the borrower. Stay Focused--and Keep It Easy! It is often suggested that you should try to go for the larger loans, preferably, well above $500,000. Among the several reasons for choosing larger loans is the issue of "ease of originating" the loan. One key item that determines whether a deal is difficult or easy to close is the ease with which you can collect the required information. If you have to beg, argue and wait forever for the documents requested, you are losing time and money on the case! Clients requiring larger loans tend to have better record-keeping habits. The larger the loan request, the higher the probability that the client or seller employs an accounting firm or property management firm to keep track of the property's cash flow. The management company's income usually depends on the property's performance. Therefore, there is less likelihood that tenants pay by cash, and even less that significant portions of the income are under-reported. Remember, you may have an excellent property and a client with good credit, but if you can not prove the property's income, you may not have a case. Ownership Structure The first thing to establish is the "owner entity." Generally, commercial properties are owned by single asset entities, corporations or partnerships who do not own any other real estate. They are formed for the sole purpose of owning one specific property. This way, problems or issues affecting other properties, or other business dealings of the shareholders, do not flow over to affect matters for the subject property. Each single asset entity files its own tax returns and financial statements, has its own bank accounts, and generally does not mingle its financial resources or reporting with that of other "sister" entities or the shareholders. The owner entity structure is easily established by obtaining copies of the certificates of incorporation, filing receipts, copies of licenses and permits. Income For a multi-tenanted property, the income is typically established by reviewing several or all of the following documents: leases, property income and expense statements (preferably prepared by a CPA), tax returns, bank statements, copies of canceled checks and--if required by local laws or regulations--other filings with the appropriate municipal or state authorities. Copies of leases are required for all legally-rented commercial and residential space. They will be reviewed for the lease start and end dates (to establish how much time is left before the lease rolls), dates of initial occupancy (to help establish stability), any options such as early termination by either the landlord or tenant, the rental amount and any rent escalation clauses being compared to market values obtained from the appraisal report, any additional income the landlord may be entitled to, such as parking, laundry or reimbursement for any expenses, and the tenant entitled to any credits from the landlord. Income and expense statements, or operating financials (reflecting only the figures associated with the specific property in question) prepared by a CPA, should cover at least the last full year of operation. Most programs require two or three years, plus a YTD statement, as well as a current financial statement showing the current assets and liabilities of the owner entity. Furthermore, underwriting may require a separate statement showing the last 12 consecutive months of operating history. For larger properties with many tenants and expenses, this is often very important, and can often benefit of the client since this clearly shows any trends. Such CPA-prepared operating statements allow for notes, comments and explanations which are not possible on tax returns. It is easier to read and follow these CPA-prepared statements than tax returns. Obviously, all of these must be consistent with the tax returns--original or amended--with which they will be checked. Usually, at least the last three consecutive bank statements covering the property management account(s) will be required. The intention is to demonstrate ongoing deposits into the account of sums reflecting the stated rental and other income, as well as show the actual outgoing expense payments. Often, a full 12 months of such bank statements will be required. A careful underwriter may also request to see a copy of the ledger as well, which should match the information on the bank statements and leases. The ledger comes in handy when more than one bank account is used, or the presence of other complications makes it difficult to track the property cash flow solely from the bank statements. If the owner collects cash from the tenants, the rental income can still be corroborated by the ledger entries, as well as periodic and regular deposits into the bank account(s) of the appropriate sums. These are evidenced by entries on the bank statements and copies of deposit slips. Regular deposits are very important since irregular or sporadic deposits suggest collection problems. Cases in which one tenant occupies a significant portion of the total available space, it may be necessary to obtain financial information on the tenant as well. This is done to show that this critical tenant has the ability to pay the market rent. Typically, this is easily achieved by reviewing the tenant's cash flow from either tax returns or CPA-prepared operating financials. If the tenant is a known public company or a major, rated corporation, the process is simplified since this information can be easily obtained through the Internet. Also if the tenant happens to be a company such as IBM or Microsoft, you are certainly free to skip this step altogether. Expenses In theory, expenses should be easier to establish and require less documentation. Typical expenses for income producing property include property taxes, insurance, utilities, ongoing repairs and maintenance, management fees, sewer and garbage/trash removal, professional services such as tax preparation or legal fees, salaries, and contract services such as snow removal or landscaping. Ultimately, the appraisal company will comment on the rationality of the claimed expenses. Property taxes and insurance costs are typically documented by showing copies of the most recent tax bill and insurance invoice. These bills actually show both the amount of the ongoing obligation as well as confirm that these are current at the start of the process, at least up to the date of the invoices. The final confirmation of these figures will come from the title report and a new invoice from the insurance company just prior to closing. Utility costs will be shown in the income and expense statements, property owner's tax returns (or schedule E for individual owners). If necessary, these can always be confirmed with the utility companies. Ongoing repairs and maintenance costs are just that--ongoing. If capital improvements are included, these will skew the expenses, reducing the Net Operating Income (NOI) and, thus, reducing the maximum-allowed loan amount. A quick indicator that something is wrong may be a significant change in reported figures over the last few years. Remember that underwriting looks for historical figures and trends in evaluating the property's ability to carry a loan. Having at least three years of expense figures before you, inconsistencies are easily corrected before submitting the loan. For underwriting purposes, management fees will be assumed at approximately five percent of the rental income or, if they are higher, the underwriter will use reported figures. This is still an expense item for "self-managed" properties since, in the event a lender must take over a property, the services of a management company would have to be retained. Owner's or Shareholder's Information The two items of information needed about owners/shareholders of a "single asset" property owner are the condition of the credit report and their experience as property owners or managers. Generally, credit scores below 650 for any shareholder or partner owning more that 20 percent of the single asset entity will begin to interfere with your ability to deliver a good loan to the client. If credit is an issue with one of several parties, restructuring the shareholder composition may sometimes offer a solution. In cases where several parties own approximately equal shares--all less than 20 percent--it will be important that the parties with good credit are the ones that have management control of the operation. Generally, tax returns are collected from the majority or management shareholders, not so much to evaluate their income, but more for the record. It is still the property financials that will determine the loan amount. However, if the shareholders are also tenants on their own property, it may be important to review their ability to pay "themselves" the appropriate market rent, especially if the occupied space represents a significant portion of the total space. However, it is important to obtain recent financial statements from all key shareholders. The age of these financial statements should not exceed 60 days and should accurately represent of their financial strength. While many loans do not ask for personal guarantees, they still have standard recourse provisions for cases of fraud, embezzlement or judicial action. A personal guarantee by a client with little net worth has little value. The owner's experience is evidenced by a resume, as well as from the contents of the financial statement, and even the credit report. Typically, borrowers ought to have the experience required to manage the property or be prepared to hire a management company to do it for them. Here is the management fee. If the property is relatively small and the borrower has excellent credit, reserves in the bank, some business experience and is putting down a substantial down payment, there may not be an issue. On the other hand, a borrower who does not own a primary residence, has never owned or managed any commercial or rental property, has little reserves and is now purchasing a 50-unit apartment building--this borrower's ability to manage the property will undoubtedly be questioned. Property Information The required documentation is essentially the same as that needed in residential cases. In a purchase transaction, the contract of sale identifying the parties is needed to specify the purchase price and any other relevant terms and conditions of the sale, such as seller financing, occupancy stipulations for the time of deed transfer or needed repairs. In a refinance, we would look for the deed. Always obtain a copy of the C of O, survey, location map and color photos of the property. Sometimes, internal photos may also be helpful, especially if there is an attempt to show significant interior improvements to the property. If any recent capital improvements were done to the property, this is the time to mention those improvements and their costs. Copies of old appraisal reports, as well as old engineering or environmental reports, would also be helpful. As a minimum, copies of old "third party" reports may save you time. Conclusion If it was your money that was being lent, you would certainly expect the underwriter to review all of the above material to confirm that the borrower indeed has the ability to make payments and would continue to repay loans in the future. You may even feel compelled to request additional material at times, just be certain that your lending decision is based on sound judgement. Therefore, as you collect the documentation, always question each document, not only for legitimacy, but also for content. Does the document fit the rest of the "presentation" and does it support the loan request? If your answer is "yes," you have accomplished your goal. Remember that the borrower will be happy to give you all the material you need, provided that you ask for it in a professional manner and the client understands exactly why the requested documents are important to the underwriter. Serafim Ivask has been actively involved in the mortgage industry for more than 14 years and is product development manager for CrossLand Mortgage Corporation, now part of the Wells Fargo Family of companies. He may be reached at (631) 843-9000 or (631) 874-3256.
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