How to Underwrite a Commercial Loan with our Guide | Tips & Requirements Included

Underwriting is a crucial step in the lending process, as it helps lenders to evaluate the risk associated with granting a loan to a borrower. It involves analyzing the borrower’s financial background, creditworthiness, and the property value or business they wish to finance. Underwriting also includes:

• Determining the appropriate loan terms and conditions.
• Preparing loan documents.
• Closing and funding the loan.

The purpose of this article is to provide a comprehensive guide on how to underwrite a commercial loan. We will discuss the key steps involved in the underwriting process, including evaluating the borrower’s profile, assessing the property or business, analyzing risk factors, determining loan terms and conditions, documenting the loan, closing and funding the loan, and monitoring and managing the loan. By following these steps, lenders can ensure that they make informed decisions when granting loans and minimize the risk of default.

Understanding the Borrower’s Profile

Understanding the borrower’s profile is the first step in the underwriting process. Lenders need to evaluate the borrower’s background, financial stability, and loan repayment ability.

The borrower’s experience is an essential factor in determining their creditworthiness. Lenders look for borrowers who have relevant experience in the industry they operate in. A credit score is also critical since lenders use it to assess the borrower’s creditworthiness. A good credit score indicates that the borrower has a history of repaying loans on time, which increases the likelihood of loan approval.

Financial statements such as income, balance sheets, and cash flow statements provide an overview of the borrower’s financial position. Lenders use this information to assess the borrower’s loan repayment ability. References from other lenders or business associates can also provide valuable insight into the borrower’s reliability.

To verify the information the borrower provides, lenders can use various methods, such as reviewing tax returns, verifying employment and income, and conducting background checks. This helps to ensure that the borrower’s claims are accurate and can be relied upon during the underwriting process.

Successful commercial loan underwriting requires thorough analysis and evaluation of the borrower’s profile. According to the Small Business Administration (SBA), lenders who follow best practices in underwriting are more likely to have lower delinquency and default rates. Additionally, a Federal Reserve Bank of New York study found that lenders who spent more time and resources on underwriting had lower default rates.

Evaluating the Property or Business

After evaluating the borrower’s background and creditworthiness, the next step is assessing the property or business the borrower wishes to finance. This involves determining the value of the property and its potential revenue streams.

The property’s value is determined by several factors, including its location, condition, and market demand. Lenders must thoroughly appraise the property to determine its current market value. The potential revenue streams from the property include rental income, sales revenue, or other cash flows generated by the business.

Lenders use financial statements such as income statements, balance sheets, and cash flow statements to estimate cash flow projections. They analyze trends in revenue and expenses to determine the business’s ability to generate cash flow consistently.

The debt service coverage ratio (DSCR) is a critical financial metric to evaluate the borrower’s loan repayment ability. It measures the property’s cash flow available to cover the debt service payments. A DSCR of 1 or higher indicates the property generates enough cash flow to cover the loan payments. Lenders typically require a minimum DSCR of 1.25 to approve a commercial loan.

For example, suppose a lender is evaluating a commercial property with an estimated annual net operating income of $100,000 and a total annual debt service of $80,000. In that case, the DSCR would be 1.25 ($100,000 / $80,000), meeting the lender’s minimum requirement.

According to a study by the National Association of Realtors, commercial real estate prices are expected to continue rising in the coming years, with strong demand for office, industrial, and multifamily properties. This underscores the importance of carefully evaluating the property or business when underwriting commercial loans.

Analyzing Risk Factors

Analyzing risk factors is a critical step in the underwriting process. Lenders must identify and evaluate the potential risks of the loan and borrower.

Some common risk factors include the borrower’s creditworthiness, economic conditions, industry trends, and property value. Lenders also consider risk factors such as interest rate, liquidity, and legal risks when evaluating commercial loans.

Lenders may require collateral or guarantees to secure the loan to mitigate these risks. Collateral can be in the form of assets such as real estate, equipment, or accounts receivable. Guarantees can be provided by third-party entities, such as the Small Business Administration, or by personal guarantees from the borrower or other business partners.

Lenders should conduct thorough due diligence during the underwriting process to minimise risks. This includes reviewing financial statements, conducting background checks, and appraising the property. Lenders should also review loan documentation carefully and ensure compliance with all regulations.

One tip for minimizing risks is diversifying loan portfolios by lending to borrowers in multiple industries or regions. This helps spread risk and reduces exposure to any single borrower or market.

Another important tip is to establish clear loan covenants and monitoring requirements. This helps to ensure that the borrower complies with the loan terms and provides early warning signs if there are any changes in the borrower’s financial situation.

Lenders must carefully analyze the potential risks associated with commercial loans and take steps to mitigate these risks to ensure repayment and reduce the likelihood of default.

Determining Loan Terms and Conditions

Once the borrower’s profile, property or business, and risk factors have been evaluated, the next step is determining loan terms and conditions. This includes deciding the loan amount, interest rate, and repayment terms.

The loan amount is determined by several factors, including the value of the property or business, the borrower’s creditworthiness, and the lender’s risk assessment. The interest rate is typically based on market rates and the borrower’s creditworthiness. Repayment terms include the length of the loan term, payment frequency, and any prepayment penalties.

Negotiating loan terms with the borrower is an important part of the underwriting process. When negotiating terms, lenders should consider the borrower’s financial situation and ability to repay the loan. Suppose the borrower has a good credit score and is financially stable. In that case, lenders may be willing to offer more favourable terms.

Various loan structures are available for commercial loans, each with its benefits and drawbacks. For example, a fixed-rate loan has a fixed interest rate and payment throughout the loan term, providing stability for borrowers. In contrast, a variable-rate loan has an interest rate that fluctuates with market conditions, which can result in lower payments and higher risk.

Another common loan structure is the balloon payment loan. The borrower makes smaller payments for a set period before paying off the remaining balance in a lump sum. This allows borrowers to make lower payments initially and may be useful for businesses with seasonal income fluctuations.

Determining loan terms and conditions requires careful consideration of the borrower’s financial situation and the lender’s risk assessment. By negotiating favourable terms and selecting appropriate loan structures, lenders can help ensure timely repayment and reduce the risk of default.

Documenting the Loan

Documenting the loan is a crucial step in the underwriting process, as it helps to ensure that all parties understand the terms and conditions of the loan. The followings are some necessary loan documents and their required disclosures:

1. Promissory note: This document outlines the loan amount, interest rate, repayment terms, and other loan conditions.
2. Security agreement: This document specifies the collateral that secures the loan, such as real estate or equipment.
3. UCC-1 financing statement: This document provides public notice of the lender’s security interest in the collateral.
4. Personal guarantees: This document may be required from business owners or partners, providing a personal guarantee to repay the loan if the business cannot meet its obligations.

Completing the documentation process accurately requires careful attention to detail. Lenders should ensure that all necessary information is included in the loan documents, including borrower and lender information, loan amounts, payment terms, collateral details, and any special conditions.

In addition, lenders must comply with all applicable regulations when documenting commercial loans. This includes ensuring that all required disclosures are made to the borrower, such as annual percentage rate (APR), finance charges, and late payment fees.

One tip for ensuring compliance with regulations is to review loan documentation carefully before closing the loan. This includes reviewing all required disclosures and ensuring that the loan terms and conditions are consistent with federal and state laws.

Finally, lenders may also consider using electronic signatures and digital documentation platforms to streamline the documentation process and reduce the risk of errors or omissions. Lenders can help minimize risk and improve loan performance by ensuring accurate and complete loan documentation.

Closing the Loan

Closing the loan is the final step in the underwriting process, where the borrower signs the loan documents, and the lender funds the loan. The following are the final steps to close the loan:

1. Review loan documents: Before closing the loan, the borrower and lender should review all the documents to ensure accuracy.
2. Schedule closing: Once the loan documentation has been reviewed, the closing date can be scheduled.
3. Fund the loan: At closing, the lender will provide funding for the loan based on the agreed-upon terms.
4. Record the mortgage: The mortgage must be recorded with the appropriate county recorder’s office to provide public notice of the lender’s security interest in the collateral.

To prepare for the closing process, lenders should ensure that all necessary documentation is complete and that any outstanding issues have been resolved with the borrower. Lenders should also communicate clearly with the borrower about what to expect during the closing process and answer any questions they may have.

During the closing process, the borrower will sign various loan documents, such as the promissory note, security agreement, and UCC-1 financing statement. The lender will also provide funding for the loan at this time.

To ensure a smooth closing process, lenders should prepare all necessary paperwork, double-check all figures and calculations, and communicate effectively with the borrower throughout the process. It’s also important to be flexible and adaptable, as unexpected issues or delays can arise during the closing process, impacting the timeline.

By taking the necessary steps to prepare for closing, communicating effectively with the borrower, and being flexible, lenders can help ensure a smooth and successful closing process.

Monitoring and Managing the Loan

Monitoring and managing the loan is a critical part of the underwriting process. It helps lenders detect potential problems early and take corrective action before they become serious.

Ongoing loan monitoring includes reviewing financial statements, assessing property value, and tracking payment performance. Lenders should also maintain open communication with the borrower to promptly address any issues or concerns.

To identify potential problems, lenders should monitor payment history carefully, looking for missed or late payments and signs of financial distress, such as declining revenue or a decrease in property value. Lenders should also assess market conditions and other external factors that may impact the borrower’s ability to repay the loan.

When addressing potential problems, lenders should take a proactive approach, working with the borrower to develop a plan to address any issues. This may include restructuring the loan, offering forbearance or workout options, or modifying the loan terms to better reflect the borrower’s financial situation.

Maintaining a positive relationship with the borrower is essential to successful loan management. Lenders can build trust and establish a productive partnership with the borrower by providing regular updates on loan performance and maintaining open communication.

Additionally, lenders should be responsive to the borrower’s needs and concerns, being flexible when possible and supporting the borrower through challenging times. By adopting this customer-centric approach, lenders can improve loan performance and reduce the risk of default.

In conclusion, ongoing loan monitoring and management are essential to successful commercial underwriting. By identifying potential problems early, working proactively with the borrower, and maintaining a positive relationship, lenders can help ensure timely repayment and minimize the risk of default.

Conclusion

Effective underwriting is critical in commercial lending. By evaluating the borrower’s profile, assessing the property or business, analyzing risk factors, determining loan terms and conditions, documenting the loan, closing and funding the loan, and monitoring and managing the loan, lenders can ensure that they make informed decisions when granting loans and minimize the risk of default.

Key points discussed in this article include the importance of evaluating the borrower’s background, creditworthiness, and financial statements; assessing the property or business’s value and potential revenue streams; identifying and mitigating risks through collateral or guarantees; negotiating loan terms with the borrower; documenting the loan accurately and complying with regulations; closing and funding the loan; and monitoring and managing the loan to ensure a timely repayment.

Effective underwriting helps lenders to mitigate risk, maintain loan performance and build a positive relationship with borrowers. The success of commercial lending depends on careful evaluation, documentation and ongoing attentiveness throughout the life of the loan.