Commercial Loan Underwriting Issues

Project Quality

What is the quality/class of this project?

A - Excellent

A class A project that is "state-of-the-art, in terms of design, location, and quality of improvements. The project attracts premium tenants and lease rates.

Consequences: Class A projects attract the best rates and terms available and lenders will often break their own pricing rules to finance these properties.

B - Good

A class B project is a solid property that may be older, have lower quality improvements, be in a less attractive location or have some minor problems. The property is well maintained and functional. Most projects fall into this category.

Consequences: Lenders rarely break rules for Class B properties.

C - Fair or Poor

A class C project is at or near the end of its useful life or its useful life as improved property has not begun. Clear signs of a Class C building is deferred maintenance, a portion of the building is uninhabitable or the building site is only partially improved (not landscaped, paved for parking or building).

Reason: Lenders are generally unwilling to provide attractive, long term financing on Class C buildings. Class C building owners should consider bridge or construction financing.

Consequences: Class C buildings require bridge financing (re-hab) to bring the property to functionality or construction financing if the improvements are beyond repair.

Ways to mitigate: Class C buildings in B locations can be repaired and maintained or re-modeled for re-use if the problem is design.

Location Quality

What is the quality of this project's location?

Projects that are in areas where the economy is growing with similar projects nearby are less risky that projects that are off by themselves or in locations among other property types (an office building in an industrial area) or in neighborhoods in economic decline. Similar nearby projects implies there is a large base of tenants in the area that could potentially become leasse's of the subject building. Likewise if there is no new construction activity or re-hab activity in the area and surrounding buildings are in neglect, this is an indication of decreasing tenant demand.

A - Excellent: New buildings similar to the existing property are being built in the area.

B - Good

There are well maintained similar property types in the area.

Reason: Difficult locations decrease the likliehood of re-leasing the property if and when the current tenant leaves. This increases the risk to the lender.

Ways to mitigate: Prove demand is in the area for similar tenants with this use. This usually occurs in urban areas where the economy is growing and/or the surrounding area is being upgraded. Evidence would include new projects being built or existing properties being re-modeled, or tenants expanding in this area.

C - Fair or Poor

The surrounding area is in economic decline, there is no new construction or re-hab activity in the area and surrounding properties have significant deferred maintenance or the building is in an undeveloped area. There is shrinking demand from tenants in this area for this type of space.

Reason: Lenders are unwilling to take the risk that properties in poor locations will re-lease if and when the current tenant leaves.

Consequences: Properties in C locations will be declined.

Environmental Issues

Is there an environmental problem or the potential to find one?

A major part of due diligence is to determine if there is an environmental problem on the property. This is accomplished with an Environmental Phase I report which is prepared by an environmental engineer. Common problems are dry cleaning plants (in retail properties), leaking underground storage tanks (UST)(industrial properties and gas stations), asbestos (apartment ceilings) and chemical spills (R and D properties). Dry cleaning plants pose a recurring problem as even the latest equipment has failed to prevent spills. It is also important to know if there ever was a dry cleaning plant on the property.

Yes or Unknown

Reason: Lenders will not take environmental risk. Any potential problems will have to be identified and mitigated before the loan is funded.

Consequences: The loan could be denied if the problem is severe or the extent of clean-up is unkown. A deposit in excess of the clean-up cost may be accepted where the problem can be monetized (the lender will also require remediation)

Ways to mitigate: Investigate a potential problem before applying for the loan and remediate if a problem is found. On smaller, conservative loans a lender might consider lenders environmental insurance. The lender might also consider an indemnity from the polluter, especially if the indemnity was from an investment grade entity.

Owner Issues

Is the borrower or an individual within the borrowing entity a felon or in bankruptcy?

Lenders generally won't lend to borrowers convicted of felonies or that are in bankruptcy. They may provide a loan to someone who has declared bankruptcy in the past. The lender will consider an involuntary bankrupcty more favorably than a voluntary bankruptcy. Lenders are most sceptical of borrowers that have declared bankruptcy to avoid foreclosure on a property. It is best to disclose this information before signing an application. Lenders conduct sophisticated background checks that include legal, criminal and credit searches. Assume the lender will find this problem. It is better for the borrower to initially provide their side of the story rather than risk the deal collapsing when this information is revealed at the last minute.

Tenants In Occupancy And Paying Rent

Will the rent from tenants in occupancy, in operation and paying rent at loan closing exceed debt service (all must be true)?

Lenders are underwriting the net income from a property from tenants in occupancy, in operation and paying rent. There is higher likelihood that a tenant with a lease but not in occupancy will negotiate a buyout and/or terminate their lease prior to the expected expiration date on the rent roll. Likewise if the tenant is not paying rent there means these revenues are not available to pay debt service. An investment-grade tenant who is no longer in occupancy but remains obligated on a lease (dark space) may allow a lender to include this rent in underwriting.

Student Housing

Is this student housing?

Rental projects for students (generally in college communities) create special problems. The projects are generally rented on an annual basis but are occupied by students only during the school term. The potential for rental defaults during unoccupied periods can be high. Maintenance costs are higher as these units generally have new tenants every year and the occupants cause more damage.

Rent Control

Is this property governed by a rent control ordinance?

Rent control obviously inhibits rental increases but the major concern to lenders is expenses. In many localities expense pass-throughs are considered rental increases and are thus limited by ordinance. If the ordinance doesn't allow revenues to increase faster than expenses lenders will pass on financing this property.

Ground Lease

Is the property on a ground lease?

Ground leases come in many forms and all are a concern for a lender. The ground lessor becomes an uninterested third party to completing the transaction. The optimal ground lease is one that has been pre-paid so there is no financial risk during the term of the ground lease. A subordinated ground lease insures the lender will not lose their collateral should the ground lessee lose the ground lease. The most difficult situation is the unsubordinated ground lease. Ground lease payments are a concern, especially if they can increase faster than the revenue generated by the property.