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Everything You Need to Know: Your Questions, Answered
A top quality mortgage broker can help you navigate through the ever changing mortgage market and help you to identify and target the best opportunities. This can easily save you much more than the broker’s fee. As a result of being “in the trenches” every single day of every single week, a good broker is at the cutting edge of what is being offered, of how far the envelope can be pushed, as well as the specific language beneficial to the borrower that has been successfully negotiated on other transactions, etc.
The key to choosing a broker is the same as for choosing any other professional. Word-of-mouth references, as well as due-diligence on the broker’s background, experience and reputation are important. Of course, it’s critical that the broker you choose is deeply engaged in the current mortgage marketplace, is a good communicator and a skilled negotiator.
Utilizing a good mortgage broker allows you to tap in to a high level of expertise and experience that can help you to best achieve your goals.
Assuming that the Borrower has made a decision to proceed and has delivered all the key documents needed to underwrite the loan to the broker, 60-120 days would be the typical range. Going from “first phone call” to a closing in 60 days requires smooth choreography among all the parties.
All key players from the borrower, the mortgage broker, the borrower’s attorney, the title company, to the bankers, the bank’s attorneys, the appraiser, engineer and environmental consultant need to be kept in forward motion because if any player drops the ball, the whole schedule can and will go awry. The most typical time frame to close a commercial mortgage is somewhere between 90 and 120 days.
Occasionally, an investment opportunity may present itself to an investor that must be acted upon very quickly. Our affiliated company, W Financial. is a direct private lender capable of closing on a transaction in as little as one week. Learn more about W Financial by visiting: W Financial
This varies from lender to lender. In some cases the answer is immediately (meaning within a day or two of initial submission), and in others it may take three or four weeks from a borrower’s acceptance of a formal application until the lender delivers a commitment letter at which time the borrower may elect to lock the rate.
It’s not an uncommon dream: Sell the co-op or condo apartment and buy a townhouse or a loft building. Live in it, collect rent and best of all, escape the sometime tyranny of co-op or condo life. If, however, the building being purchased has more than 5 apartments (and/or contains commercial space making it a “mixed-use” property), the cookie-cutter financing provided to buyers of 1 – 4 family homes disappears from the radar screen. If the buyers seek financing, they will be looking for a commercial, not a residential mortgage.
Many buyers assume that they can obtain financing for around 75% of the purchase price. The fact is that they can usually borrow about 75% of the property’s appraised value. Depending on a variety of factors, ranging from long-deferred maintenance to low rents being paid by rent-regulated tenants, there may be quite a disparity between the property’s purchase price and its appraised value. This can result in quite a surprise for a buyer who may need to provide considerably more equity than was initially expected. Today’s low interest rates are certainly helpful, but they will not necessarily result in higher loan amounts due to such valuation constraints.
It is common for a “gap” to exist between the premium price that a Manhattan brownstone or townhouse commands in the marketplace and its appraised value as seen “through a lender’s eyes”. Part of the explanation for the “gap” pertains to elements of ownership that will benefit an owner/occupant, but would be meaningless to an investor. While the lender will size up a property much like a serious real estate investor, concentrating on the property’s cash flow, an owner-occupant enjoys benefits such as living in the property as well as tax benefits which may justify paying a premium price.
A typical recent example involves an eight-unit, Upper West Side townhouse in contract for $4,450,000. 75% of the purchase price would be $3,337,500. However based on the actual income and expenses of the building a lender would barely be able to justify a $3,769,494 value (see chart on page 2). Even if the lender is willing to consider a blend of the sales price of the property and it’s value to an investor, the appraised value may still not exceed $4,059,747. 75% of $4,059,747 is only $3,044,810, which is $292,690 less than the mortgage amount the buyer was hoping for. Yet based on the above income and expense assumptions, ~$3,250,000 is a loan amount that would likely be comfortable for a number of lenders.
Vacancies in a prospective property present less of a problem as lenders are usually willing to attribute “market rents” to those units. Lenders generally assume that the building’s new owner will be able to fill the vacant units within a reasonable amount of time. Of course, the lender will also check public records (DHCR filings, etc.) to ensure that any vacant units are free of rent restrictions. The buyer cannot automatically presume that a vacant unit can be rented at “market value.” Over time, rents may be increased via vacancy and renovations above $2,000 and therefore become deregulated. If a unit that will be owner-occupied could be rented for, say $10,000 per month, lenders will typically include such market rents in their income calculations.
“Projected” rent rolls often make sweeping assumptions about what might happen in the future if all goes perfectly according to plan. A buyer may see huge upside potential in a given property, assuming that deals can eventually be struck with low rent-paying tenants, but a lender will be acutely aware of the risk that any rent-regulated tenant(s) may not leave.
Let’s take a very basic look at how a lender typically analyzes the cash flows in a multifamily rental property. For the sake of simplicity, let’s assume for this example that there are no stores or other commercial spaces: Purchase Price: $4,450,000 | Proposed mortgage amount: $3,200,000 (73% of purchase price, 75% of value)
Start with the gross annual income: [$470,088]
- Now subtract a 5% vacancy allowance from that number: [-$23,504 = $446,584]
- Now take that result and subtract a 5% management allowance: [-$22,329 = $424,255]
- Next subtract the actual current expenses (We’ll assume $85,000 for this example). Remember to include all other typical categories such as: RE taxes, water and sewer taxes, fuel, utilities, payroll, repairs and maintenance, legal & accounting, replacement reserves, and miscellaneous (each lender will have their own way of estimating these expenses based on their past experiences). For small buildings with 10 or fewer units, some lenders will plug in $300 or $400 per unit for management expenses rather than 5% of the income).
- The resulting number is your net operating income (NOI). [$339,254]
- Now plug in the annual interest and principal payments for your proposed mortgage amount with a realistic “ballpark” estimate for the interest rate and amortization schedule. As of 6/18/03, let’s assume a 4.75% rate amortizing on a 25-year schedule: [$226,478]
- You should now be able to multiply your annual debt service by 1.25 and get a number equal to, or less than, the net income [$339,254]. If the property you are seeking to buy passes this test, then there are probably a number of lenders who will be interested in financing it for you. If your prospective purchase does not pass the test, reduce the loan amount until it does. This will give you a very realistic way to “screen” properties to see what you can comfortably afford to buy.
- This example yields a debt service coverage ratio (DSCR) of 1.53, which is comfortably better than the minimum 1.25 coverage that most lenders would seek (Net Operating Income [NOI] = $339,254, divided by (annual debt service $222,346) = 1.53. Although the required DSCR varies according to property type and from lender to lender, it is a simple enough concept. It is essentially a “cushion” that assures the lender that even if some income is lost during the course of the loan term for some reason, the borrower will still have sufficient income to service the mortgage on the property.
Even when a building passes the DSCR test comfortably (as in this example), there are other parameters that lenders and appraisers use that may limit the loan amount, such as what capitalization rate is deemed appropriate, and whether the lender gives more weight to the income approach or to the sales approach.
There are plenty of variations on the theme of how different lenders evaluate, define valuations and establish loan amounts based on many details that are not readily apparent to the borrower. However, a conceptual understanding of how lenders approach underwriting a multifamily loan will be helpful if and when you or your client are exploring this market.
Methods to minimize the impact of prepayment penalties: Currently, many borrowers are faced with a dilemma: Should they refinance now and pay a significant penalty, or should they wait until the penalty disappears, hope that rates are still attractive and refinance at that point in time? There is a very interesting solution to solve this dilemma. I am pleased to report that we are handling several transactions where we are locking in an interest rate now for a borrower where the closing will not occur until much later. In some cases, the closing can occur 10, 11 or even 12 months from the day that we initiate the process. This can allow a borrower to achieve the best of both worlds:
- to lock in lowest possible interest rate now, and
- to minimize the prepayment penalty on their current loan.
Any borrower with either a fixed or a yield maintenance prepayment penalty with 12 to 24 months remaining until maturity can benefit from this forward commitment and early rate lock program. Please give us a call if you would like to discuss in greater detail whether this program would be beneficial to you or your client.
Yield Maintenance is a prepayment penalty that, in the event the borrower pays off a loan before maturity, allows the lender to attain the same yield as if the borrower had made all scheduled mortgage payments until maturity. Yield maintenance premiums are designed to make lenders indifferent to an early prepayment by a borrower. On the flip side, it can mean that if a borrower currently has a 9.5% rate on its mortgage with 5 or 6 years to go until maturity, at this time the penalty could well be huge.
For example, let’s assume a 15-year interest-only $1,000,000 mortgage at 7%. After the 5th year the borrower decides to refinance. The yield maintenance prepayment penalty would equal the difference between the current 7% rate and the yield that the bank would receive reinvesting the loan proceeds in a 10 year Treasury Note. (10 years being the remaining term of the loan).
To keep this example simple, let’s say that at the time of prepayment, the 10 year Treasury note is 5%. The borrower would be required to pay the lender the present value of the 2% difference for each year over the loan’s ten remaining years, or $200,000. This penalty will make the lender “whole” and insure that the lender will not experience an economic loss as a result of being paid prior to the loan’s maturity. This same formula applies to amortizing loans, however it is much easier to illustrate with an interest-only loan.
Each lender will have a slight variation to this formula, however the above example conveys the spirit of the yield maintenance penalty.
Sometimes a new client will ask what issues tend to come up again and again during the commercial mortgage financing process and what mistakes they should try to avoid. Here are the top seven mistakes that come to mind. As you’ll see, most of these fall under the general topic of “timing is everything”:
1) Searching too hard for the “bottom” when choosing the moment to lock an interest rate-Focus on the monthly/annual payment being within your target range. DO NOT focus on hitting the absolute bottom.
2) Working with multiple brokers –
The myth is that taking this approach benefits the borrower because it generates more market coverage and insures a better result. In the borrower’s mind the math goes something like this: “more brokers means more offers which should result in a better deal for me”.
The fact is that when lenders start seeing the same loan submission coming in from multiple sources they assume that no one is actually in control of the deal. Lenders are less likely to put their best efforts forward in such a fuzzy environment.
The borrower’s best strategy is to do some meaningful due diligence, check references and select a knowledgeable, well-staffed and reputable broker. Exclusively engage that broker for a finite period of time, and allow that broker to work the entire marketplace to obtain the best pricing and structure.
3) Failing to recognize and effectively negotiate significant deal points in the lender’s offer letter right at the beginning.
For commercial mortgages, a lender’s initial offer letter or term sheet is typically short on fine detail. Nevertheless you should bring up any significant points that are important to you at this early stage. Various important deal terms may be much more difficult to modify later on, once the loan has been approved and the commitment letter has been issued. The offer letter stage is the time to address tax escrows, the lender’s calculation method (30/360 or Actual/360), issues of timing (rate lock, closing schedule), and any other points that may be of importance to you BEFORE you’ve posted a good-faith deposit.
4) Assuming (especially in NY state) that the mortgage can be assigned, but waiting too long to see whether: a) the old lender will cooperate, b) all the necessary original documents are available, and that c) your attorney prepares a draft assignment in a timely manner.
5) Not considering all of the currently available loan products for your situation–
Lots of owners know one or two lenders and fall into the habit of calling the same one or two lenders with whom they are comfortable when it’s time to refinance an old property or to finance the acquisition of a new one. This is a good habit to overcome. The financing marketplace is ever changing. To get the best result you need to scan (or have a good broker scan) the overall landscape in order to determine your best move. There may be players and products that an owner/borrower is unaware of that may turn out to be the most logical fit, and the smartest business move.
For example: Perhaps you own 10 apartment buildings and have always tended to choose typical “5 and 5” type loans. This time, take a fresh look. The marketplace is fluid, as are the interest rates. With the 10-year Treasury currently (as of June 16, 2003) at 3.17%, a 10 year fixed rate deal at 4.25% might be worth a close look. With 30-year fixed rates available below 5%, a long term, fully amortizing loan might well be worth considering. If you’re planning a sale in the near term, a LIBOR-floater might be a good idea, as it will have an amazingly low rate (perhaps below 4%), and no prepayment penalty.
6) Using the wrong lawyer–
Sometimes a borrower feels compelled to use a lawyer who is a friend, or perhaps his brother-in-law (who happens to be a matrimonial or estate attorney) to close a commercial Real Estate transaction. My advice is simply: Don’t! Most borrowers will end up saving money and perhaps shaping the terms of the deal far more to their liking if they hire a seasoned pro. Using a lawyer who is inexperienced in this very specialized area will only run up the bank attorney’s bill, and may well cause the borrower to need to extend the time to close, which may result in additional fees and penalties, etc. The best advice to achieve a smooth closing is to choose a real estate lawyer who is a seasoned pro in this very specialized (commercial vs. residential) field.
7) Failing to give adequate notice–
One possible consequence of making the wrong choice for #6, or the wrong choice of broker might be failing to give adequate notice to the CURRENT lender that their loan is soon to be paid off. Make sure to check and act upon the notice requirement on the outgoing loan BEFORE locking the rate on a new mortgage.
Half the battle is simply taking the appropriate action at the right time. Good timing can help you win almost every deal point the next time you negotiate a commercial mortgage.
We’re all aware of the “time value of money”. Well we should also compare the strategic value of a simple action taken at the right time, vs. the value of the same action taken too late in the game. The difference can (and usually does) amount to an easy task that has now been transformed into a pressure-cooker, error-prone, last minute nightmare. Whenever possible, use the fallow time (between accepting a lender’s offer and receiving the commitment) to your best advantage, clearing as many obstacles out of the way as possible.
Anticipate the Obvious:
While no one can ever anticipate every possible contingency or problem that might arise during the financing process, it’s fairly simple to anticipate a number of routine occurrences and requirements, and to sweep as many of them out the way as early in the process as possible. Clearly, once you have accepted an offer from a lender and you’re waiting for the commitment to be issued, it’s usually a good idea to pull the trigger and order the title searches. Most real estate attorneys can order the title work from a company that they regularly use which is willing to assume the risk that if the deal does not close, there will be no fees for the searches.
Since title work is still one of the more primitive and time-consuming parts of the process, the earlier you start, the better. That way there will be plenty of time to deal with delays and to resolve pesky violations or other issues that may arise before the stress-laden pre-closing days arrive.
With regard to the survey, at the very least, make sure you’re aware of the new lender’s requirements. For example, if your new lender will require an ALTA survey, and the old survey was not prepared to those specifications, order it once you’ve accepted an offer rather than waiting for the commitment as the survey could easily take 4 – 6 weeks. Many surveyors are currently quite busy and not famous for quick turnaround, so by all means don’t leave this until the end.
Assignment of old mortgage – 1) God-given right, or 2) professional courtesy typically extended?:
” What do you mean, I’ll have to pay $154,000 in mortgage tax?!!!!”
No one wants to pay any more mortgage recording tax than absolutely necessary. Remember that if the property is in New York City, the borrower will have to pay mortgage recording tax for loans above $500,000 of $27,500 per million. Clearly you will want to minimize this tax by having your new lender take an assignment of the old mortgage. Let your new lender’s attorneys review, comment upon and approve the old mortgage and note early, rather than late, in the process. This is one more simple step that you and your attorney can take to minimize stress in the days leading up to your closing.
Don’t paint yourself into a corner:
With regard to the structure of the loan, at the outset, consider all the different ways your project may play out and plan appropriately. For example, if there is a chance that you will convert your newly acquired multifamily or mixed-use property to condominiums sometime down the road, you will want to be 100% sure that your lender will agree to having their loan repaid as units are sold (and as their collateral is whittled away). A long-term fixed rate might be a terrific play given today’s interest rates, but not if you might convert your new project to condominiums and may therefore need to prepay your mortgage incrementally.
Similarly, if there’s a good chance that you might sell the property within a few years of your closing, plan carefully about your prepayment penalty and/or your new lender’s willingness to permit a buyer to assume the mortgage.
To sum up: There are enough things that can go wrong and/or cause delays. In order to achieve a smooth closing, use any slack time to move as many of the obvious tasks from the “to do” column to the “completed” column sooner, rather than later. When crunch time comes just before the closing, you’ll want to be concentrating on any important loose ends in the mortgage documents, rather than being distracted by the trivia and “white noise” of routine tasks that should have been completed weeks earlier.