NMP - December 2016 - 72


The Basics of
Mortgage U
s a commercial
mortgage
underwriter, broker
and lender with
more than 30 years
of experience, I am
constantly asked by residential
lenders and brokers to explain
the mechanics of commercial
mortgage underwriting.
Residential lenders are
accustomed to asking about a
borrower's income, credit, net
worth, liquidity and debt-toincome ratio. Commercial
lenders ask those same
questions, but also need to
understand the cash flow of the
underlying commercial property.
There are various mathematical
calculations that are employed in
this cash flow analysis.
I will define and attempt to
explain these calculations in a
logical sequence, as follows:
l Potential gross income: This
represents the maximum
income to be realized from the
property. For example, let's
say that a borrower owns a
10-unit apartment building
with average rents of
$1,000/month. The potential
gross income would be
$120,000/year (10 apartments
x $1,000 x 12 months). This
$120,000 doesn't tell us
enough yet, but it is our
starting point.
l Operating expenses: Every
building has expenses,
including real estate taxes,
insurance, utilities,
maintenance and repairs,
garbage, landscaping, etc.
These operating expenses
need to be reviewed carefully
as many sellers, owners and
real estate agents often
understate actual expenses
when selling a property.
l Underwritten expenses:
There are certain expenses
that are always overlooked by
sellers and brokers, but
assumed by underwriters.
These include vacancy factor,
management fees, repair
allowances, tenant

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72

improvements and leasing
commissions. Underwriters
will assign a vacancy factor
(say five percent) to allow for
lost rents during tenant moveouts and tenant move-ins.
Management fees are required
(again, say five percent) to pay
for management duties even if
performed by the owner.
Repair allowances cover
unforeseen expenses and
building repair for non-regular
events such as a new roof or
new boiler. These events do
not occur annually, but must
be budgeted. Commercial
properties, such as retail and
office buildings, might also
require tenant improvements
to lure a new tenant and
leasing commissions to a real
estate broker. All of these
expenses will be estimated by
the underwriter.
l Net operating income: The
operating expenses and
underwritten expenses will be
subtracted from the potential
gross income to generate
what is known as the net
operating income. This is the
building's net profit before
debt service, or mortgage
payments.
l Annual debt service: This
represents the total annual
payments for the existing or
proposed mortgage. For
example, if the monthly
mortgage payment is $2,000,
we say that the annual debt
service is $24,000. The debt
service needs to be
adequately covered by the net
operating income. This
concept is explained next.
l Debt service coverage ratio:
This is the first of two main
ratios considered by a
commercial mortgage
underwriter. The debt service
coverage ratio (DSCR) is
calculated by dividing the net
operating income by the
annual debt service. As an
example, say a building has a
net operating income of
$125,000 and proposed


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Table of Contents for the Digital Edition of NMP - December 2016

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