Understanding Reserve Levels with Commercial Underwriting
Apr 06, 2017
Risk to the lender is inherent to any loan, but commercial loans are particularly fraught with it. Although commercial properties may have income coming from tenants/leaseholders, there are still ownership risks, from vacancies to unforeseen large capital improvement expenditures. Unfortunately, all types of commercial loans can result in the lender’s position being compromised.
Of course, banks have plenty of ways to avoid and measure out these risks. Through the commercial mortgage loan underwriting process, they can vet the credit worthiness of borrowers and agree to fund loans. By verifying things like tangible net worth and credit history, they settle one question: How likely is it that this commercial borrower will repay?
Reserve Levels and Commercial Real Estate Investors
It’s important to note that not all commercial lenders utilize capital reserve requirements, but for those lenders that do, it helps to ensure that property maintenance and upkeep are managed throughout the loan term. However, many who get involved in commercial real estate investing run into underwriting trouble with a lack of clear knowledge on the subject. Let’s fix that, why don’t we?
What are Commercial Capital Reserve Levels?
Commercial reserve levels are all about assets; specifically, ensuring there are enough liquid assets to cover the loan for a period of time. How much has the borrower allocated to prepare for down payments, closing costs, and mortgage payments for a period of time? How much do they have prepared in case tenant vacancies arise?
Alongside the other factors evaluated in the underwriting process, meeting a reserve level indicates that a borrower is coming to the commercial lender financially prepared to take on the commercial loan in the instance anything comes up.
Asset Reserve Requirements
There are two types of reserves: bank reserves and capital reserves. Bank reserves generally define their asset requirements in terms of Principal Interest Taxes and Insurance, or PITI. This refers to a borrower’s ability to cover the associated costs of their mortgage, including principal, interest, taxes, and insurance, for a specified number of months.
The other type of reserves is referred to as capital reserves. Capital reserves can come in the form of capital the borrower is required to escrow, and are usually calculated on a square footage or per unit basis (i.e., $450-650 per unit or maybe $0.50 per square foot).
Tips for Acceptable Assets
It may come as a surprise, but not all assets are viewed equally. Here are a couple tips to ensure yours will count in the eyes of the bank during the commercial underwriting process.
1. Ensure assets are in personal accounts.
Generally speaking, banks want to see liquid assets that can easily be used to cover PITI, so most lenders will only fully count assets in your personal accounts. Conversely, lenders will usually only consider a portion of your retirement or brokerage accounts – or not at all. Takeaway: Setting aside assets in your dedicated accounts will help during the underwriting process.
2. Bring your paperwork.
Ultimately, what the banks want to see is documentation of the commercial reserves. Many commercial investors shift money between accounts as financial needs arise, but liquid assets need to have the accompanying paperwork to establish ownership.For your capital commercial reserve levels, ensure the documentation is in place.It’ll do the commercial lender (and yourself) a big favor.
Again, the basic reasoning behind the reserve level is ensuring a person has the money to take on the commercial mortgage in case any expenses arise during the commercial loan term, so it’s important to provide information to show just that. Anything that might indicate otherwise will work against you.
Reserve Level Requirements vs. Hard Money Loan Requirements
If banks determine whether or not to fund commercial loans based on a borrower’s assets, how does this differ from asset-based financing such as hard money loans? After all, both require assets for lending. Well, unlike the bank underwriting process which requires information about assets as well as credit and income, hard money loans are focused on the collateral. Hard money lenders determine the value of their loans based on the value of the subject property being put up as collateral.
Picking Commercial Financing That’s Right for You
The traditional commercial lending process doesn’t suit all situations, just like hard money loans don’t suit all situations. The underwriting process can be prohibitive for commercial real estate investors or business owners who have shorter windows to act, are limited by credit, or who haven’t seasoned the assets they’ll need in preparation. Fortunately, in these cases, hard money loans can help.