Loan underwriters often refer to the five Cs of credit when evaluating and underwriting loan applications. What are the five Cs and how do they affect mortgage lending on apartment properties? The five Cs are: capacity, capital, character, collateral and conditions. We will attempt to explain each of these items and their effect on apartment lending credit decisions.
Capacity is defined as the borrower’s ability to pay the outstanding debt. The borrower (or borrowing entity) must be able to generate sufficient cash to make the monthly mortgage payments. When it comes to lending on apartment assets, the net operating income (NOI) must be sufficient to cover the proposed payments. A lender will analyze the rent roll, occupancy, rental trends and property condition to ensure that the property will generate positive cash flow into the future. Underwriters will calculate a debt service coverage ratio (DSCR), which is defined as NOI divided by the annual mortgage payments. A positive number reflects a cash flowing property. Lenders will usually expect to see a DSCR of at least 1.20.
Capital is defined as the borrower’s net worth and liquidity. Lenders will expect the borrower to have enough capital for a down payment of at least 20 percent in the case of an apartment building purchase. This 20 percent down payment should come from the borrower’s cash reserves and not be borrowed. In addition, underwriters will expect to see cash reserves (after down payment) in order to cover unexpected expenses, such as emergency repairs, renovations and improvements. Typically, underwriters on apartment loans will expect to see cash reserves equal to approximately nine months of mortgage payments.
Character refers to the borrower’s ability and desire to make the proposed payments. Specifically, character addresses the borrower’s past credit history with regard to making payments. Lenders on apartment properties will often look at the borrower’s credit scores and expect to see a minimum score of 680. Lenders will also look at past bankruptcies, foreclosures, short sales, judgements and liens. If any of these conditions exist, the borrower will be expected to document and explain the source of the problem and demonstrate to the lender’s satisfaction that these issues have been corrected. Past credit issues are not cause for an immediate rejection, but need to be addressed upfront in the loan application process.
Collateral covers the actual apartment property. Lenders will expect to see a property in good condition and in a good neighborhood. The property will need to be cash flowing and have a high occupancy rate. Properties under construction, renovation or with high vacancy rates will typically not qualify for traditional financing. The underwriter will look at the rents and expenses to make sure that they are reasonable and in line with similar properties. Lenders will require an appraisal and will typically lend up to 80 percent [of the price] on a qualifying apartment property.
Conditions cover a few topics from both the lender’s and borrower’s perspective. The lender will want to analyze conditions in the neighborhood of the property. Are rents increasing or decreasing? Is the neighborhood supported by an active labor market and are local jobs available for residents? Is the property desirable or are there newer properties available for rent? Does the property offer amenities necessary to maintain high occupancy? On the borrower’s side, do the lender’s lending conditions satisfy the borrower? Is the lender able to offer the appropriate loan amount at a favorable rate and on favorable terms? Will the lender require personal guarantees? Are closing costs within reason?
Apartment mortgage lenders have a lot to consider when analyzing a loan request for an apartment building. They will analyze the borrower personally, as well as the property. Borrowers should be able to produce the necessary and requested documentation upfront to avoid processing delays. Any negative information about the borrower or property should be disclosed and explained upfront. A borrower that understands what a lender needs will have a higher chance of approval.
Stephen A. Sobin has more than 30 years of mortgage lending experience. He is president and founder of Select Commercial Funding LLC (www.selectcommercial.com), a nationwide commercial mortgage brokerage company. Sobin is a proud member InterCapital Group, a nationwide alliance of commercial mortgage professionals. He can be reached at 516-596-8537.
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