Chapter 18:(Section 18.2 only)Commercial Mortgage UnderwritingChapter 18: (Section 18.2 only) Commercial Mortgage Underwriting“Underwriting”= Process lenders go through to decide to issue a commercial mortgage, and the terms of the loan:Loan Origination (“primary” market).“Underwriting” = Process lenders go through to decide to issue acommercial mortgage, and the terms of the loan: Loan Origination (“primary” market). z Often a negotiation type process (esp. for largeloans): Commercial Mortgage business is a“custom” shop. z Standard criteria may sometimes be “bent” (esp.for large borrowers, or when the market is “hot”),but provide the basic guidelines.Basic Purpose of Underwriting:But no one can operate “outside the market”…Supply & Demand:Basic Purpose of Underwriting: Î To make default a rare event. But no one can operate “outside the market”… Supply & Demand: • Most borrowers cannot (or do not want to) conform to underwriting standards so tight as to eliminate default risk (even if that would get them T-Bond interest rates). • Lenders must conform to the market in order to “play the game”: Modify loan terms so that E[r] is sufficient to compensate for default risk.Two Foci of Underwriting:Borrower & Property1) Borrower:Two Foci of Underwriting: Borrower & Property 1) Borrower: On the downside: i) Can “bleed” healthy property as “cash cow”. ii) Can use Ch.11 if they get in trouble (“cramdown”). iii) Financial health of borrower is important. iv) Check “parent” company. On the upside: i) Potential “repeat customer”. ii) Consider size, track record, future potential.2) Property:Generally more important than borrower:Standard Property-level Underwriting Criteria:Two Foci of Underwriting:Borrower & PropertyTwo Foci of Underwriting: Borrower & Property 2) Property: Generally more important than borrower: i) Main source of CF to service loan. ii) Comm.Mtgs effectively “non-recourse”. iii) Careful lender w well-crafted loan: strong property counts more than strong borrower. Standard Property-level Underwriting Criteria: i) Asset value criteria... ii) Property income criteria...Asset Value Criterion:Initial Loan-to-Value Ratio (LTV)Asset Value Criterion: Initial Loan-to-Value Ratio (LTV) LTV = L/V Exh. 18-5: Typical relationship between initial LTV ratio and the ex ante lifetime default probability on a commercial property mortgage: LTV Ratio Default Prob.Relation between:• LTV,• Property Risk (volatility), • Loan Default Probability.A simplified example…Suppose…• Initial Prop. Val = $100, E[g] = 2%/yr.• 75% LTV (No amort Î OLB = $75 constant).Relation between: • LTV, • Property Risk (volatility), • Loan Default Probability. A simplified example… (Text box p. 447) Suppose… • Initial Prop. Val = $100, E[g] = 2%/yr. • 75% LTV (No amort Î OLB = $75 constant). •Average loan default occurs in year 7 of loan life. • Individ. Prop. Ann. Volatility (Std.Dev[g]) = 15%. • Prop. Val follows random walk (effic. mkt.). • Î T yr Volatility T (Ann.Volatility )=Relation between:• LTV,• Property Volatility, & • Loan Default Probability.A simplified example…Relation between: A simplified example…• LTV, • Property Volatility, & • Loan Default Probability. Thus, After 7 years: • E[Val] = 1.027(100) = 115 • Std.Dev[Val] = 7 (15%)(100) = 2.6*15%(100) = ±40%(100)= ±40. • 1 Std.Dev below E[Val] = $115 - $40 = $75. • If Prob[Val] ~ Normal, Î 1/6 chance Val < OLB, Î Loan “under water” (large chance of default in that case).Greater Property Volatility (Risk) ÎLower LTV corresponds to a given lifetime default probability.ÎLower Max LTV Limit in underwriting criteria.The point is . . .The point is . . . Greater Property Volatility (Risk) Î Lower LTV corresponds to a given lifetimedefault probability. Î Lower Max LTV Limit in underwritingcriteria. Typical LTVLTV limit in commercial mortgages ongood quality stabilized properties is 75%75%. • Based on lower of appraisal or purchase price. • Based on lower of DCF or Direct Cap. • Sometimes “bent”, or fudged in appraisal, due to market pressure.Property Income Criteria…1) Debt Service Coverage Ratio (DCR):Property Income Criteria… 1) Debt Service Coverage Ratio (DCR): DCR = NOI / DS Typical: DCR >= 120%2) Break-even Ratio (BER):Î Occupancy ratio required for EBTCF > 0 (exclu CI)Î Lender usually requires BER < (100% - Mkt Vac)Typical: BER <= 85%, or less than mkt avg occupanceminus some buffer (typically 5%).2) Break-even Ratio (BER): BER = (DS+OE) / PGI Î Occupancy ratio required for EBTCF > 0 (exclu CI) Î Lender usually requires BER < (100% - Mkt Vac) Typical: BER <= 85%, or less than mkt avg occupance minus some buffer (typically 5%).3) Equity Before-Tax Cash Flow (EBTCF):3) Equity Before-Tax Cash Flow (EBTCF): EBTCF = NOI – DS – CI Similar to DCR, only includes effect of CI. Projection of EBTCF < 0 any year of loan Î “Red Flag”.4) Multi-year Pro-Forma Projection:4) Multi-year Pro-Forma Projection: In principle, lenders project income ratios for all years of loan life.Variables and loan terms to negotiate:• Loan Amount• Loan Term (maturity)• Contract Interest Rate• Amortization rate• Up-front fees and points• Prepayment option and back-end penalties• Recourse vs. Non-recourse debt• Collateral (e.g., cross-collateralization)• Lender participation in property equity• Cramdown insurance • Etc. . . .Variables and loan terms to negotiate: • Loan Amount • Loan Term (maturity) • Contract Interest Rate • Amortization rate • Up-front fees and points • Prepayment option and back-end penalties • Recourse vs. Non-recourse debt • Collateral (e.g., cross-collateralization) • Lender participation in property equity • Cramdown insurance • Etc. . . .Underwriting ExampleThe Problem:•Should you do the deal?Underwriting Example The Problem: • Buyer (borrower) & seller claim property worth $12,222,000; • Buyer wants to borrow 75% ($9.167 Million, or $91.67/SF) from you (mortgage lender), for purchase-money 1st mortgage; • Wants non-recourse, 10-yr interest-only loan, monthly pmts; • Willing to accept “lock-out”. • Should you do the deal?Current Capital Market Information:Î 7.87% MEY required YTMUnderwriting Example (cont.)Underwriting Example (cont.) Current Capital Market Information: z In Bond Mkt: 10-yr US Govt