The ASG Companies
The Underwriters Narrative should represent a consistent outline in which information is gathered in a similar fashion and evaluated according to the individual characteristics of the loan and the property that provides the cash flow. One can think of the Underwriters Narrative as an outline which can contain anywhere from six to seven sections or more depending on the way the information is characterized or outlined.
I. Executive Summary
The Executive Summary is probably the most single important section of the entire report. It should inform the reader within less than two pages the terms and conditions of the loan, the results of the technical third party reports and a brief, concise, well-written summary of the transaction.
Investment bankers and/or rating agency personnel want to understand the entire deal in a one or two page summary that is actually supported by the remainder of the report. The last paragraph discusses the net worth of the sponsor indicates whether the sponsor has a significant net worth in relation to the specific loan amount and on a portfolio basis how this compares to other sponsorship for other loans in the pool. The sponsorship issue is a quality issue that will become more and more important in the next several years.
One of the initial aspects to discuss is the Sources and Uses of funds for the transaction. This section in a table or chart format should identify all cost associated with the transaction including but not limited to the loan amount, the payoff of the existing mortgage, and closing costs. This is also a good section to discuss the borrower equity in the transaction as a percentage of the value of the deal.
Sources and Uses (Example)
Initial Capital Reserves
II. Property Analysis Section
Again in a table or chart format individual property characteristics should be identified. Specific characteristics should include year built, year renovated, number of buildings, gross square feet, net square feet, number of stories, land size, parking spaces, number of tenants, number of units (for multifamily), number of doors (industrial buildings), ceiling heights, % of office space, % of retail space, and % of warehouse space. Any property type such as office, retail, multifamily, warehouse, hotel or mixed use could have separate charts for the individual property type and be incorporated into a specific form.
A thorough narrative discussion should accurately describe the subject property from both a physical characteristic viewpoint and an opinion of the type of property whether it is a Class A/B/or C. The commentary needs to include a discussion of the tenant mix including length of the tenancy and types of businesses. Other aspects should include an analysis of ingress/egress from the street, visibility issues and identification of the specific zoning for the subject property.
III. Next the Macro Market Analysis
Once property specific issues have been completed, how does that property or type of property relate to the larger market or economy? In general terms the larger market or metropolitan area should be discussed. The subject property in relation to the Central Business District in terms of miles and geographical direction should be identified. Various facts and figures including numerous economic statistics should be identified. Population statistics and trends should be discussed. The economic base and the top 10 employers should be identified. Sources of this information can include national type brokers such as CB Richard Ellis and Colliers. Whatever property type is being underwritten general market information regarding average rents and market occupancies should be discussed. This aspect of the Loan Presentation should inform the reader on a Macro level the economic and market dynamics of a specific region of the country as it pertains to a specific property market.
IV. Submarket Analysis
Once the Macro Analysis is completed a specific submarket analysis evaluates the subject property in relation to comparable properties, the neighborhood and immediate market. The market rents, market occupancies and market expenses can be compared to the subject property and it can be determined whether or not the subject's rents, occupancy and expenses are consistent with the market. Obviously if there are discrepancies further research and analysis has to be completed and explained. Again the use of charts and tables may be utilized to compare the subject property with the comparable properties which are most often utilized from the appraisal. The comparable rental analysis chart should include specific property characteristics.
For example the physical address of the properties, distance from the subject, building size in terms of square feet, year built, year renovated, occupancy, type of leases (net or gross), type of space, average lease term, concessions, effective rental range, typical expense reimbursements, tenant improvements, leasing commissions and a discussion of historical rental rate trends and historical occupancy trends. Finally the comparison should be made to the subject property as to whether the comparable property is superior, inferior or similar to the subject property. Other specific areas to be discussed would include any military or student impact, surrounding land uses and planned construction in the immediate area. Conclusions should summarize market stability and trends.
V. Income and Expense Analysis
For office, retail and industrial properties, a review of the leases and summary of tenant's businesses needs to be evaluated. Any commercial tenants occupying more than 5,000 square feet of square will need to have a separate lease review forms completed which details the actual terms and conditions of the lease. Any material issues should be discussed in detail for example co-tenancy, blowout provisions, unusual landlord obligations, environmental indemnities, concessions, rent escalations, etc. The actual lease rents should be compared to market rents with any discrepancies fully explained. Lease retention assumptions typically include 50% to 65% and should be based upon the history of the tenancy at the subject property.
For multifamily properties the tenant profile completed by the borrower discusses the types of tenants, occupations and income level.
Perhaps the most important aspect of the entire Underwriting Narrative is the discussion and explanation of the historical and underwritten income and expenses. Three years of historical income and expenses should be identified and analyzed in a consistent spreadsheet or template. A year to date and/or trailing 12 months for multifamily properties should be included. A column for the appraisal estimate of income and expense should also be identified. Every component of income and expenses should be analyzed and discussed in great detail as a comparison to previous years. Finally, the underwritten income and expenses should be concluded based upon the historical operations of the subject property.
A. Income Section
The Gross Potential Income is derived from a current rent roll that the borrower has provided. This rent roll identifies the tenant, amount of square feet, date of lease commencement and expiration. Any percentage rent from typical retail type tenants should be discusses if any. Expense reimbursements based upon the actual leases should be compared to the historical collections of the subject property. Net Rental Income should be categorized as a separate line item. Next Vacancy and Credit Loss should be discussed in detail as compared to the appraiser's estimate, the historical amounts and the current vacancy at the subject property. The last category would include any "Other Income" which as not already been identified. The calculation of Effective Gross Income is simply the result of Gross Potential Income less Vacancy and Credit Loss. The Effective Gross Income should be compared to the historical collections and the appraiser's estimate.
Typically office buildings, industrial facilities and retail developments have similar operating expenses and similar templates can be used for the itemization of several expenses. These expenses typically include real estate taxes, other taxes, hazard insurance premiums, common area expense that can include utilities, repairs and maintenance. Other expenses include the management fee and other administrative/payroll/office expenses that are attributable to the particular type of property.
For multifamily properties a thorough and detailed explanation of numerous expenses should be undertaken to determine all of the expenses for an apartment property. Again fixed expenses such as real estate taxes and insurance should be discussed in detail. Utilizing the following categories can differentiate variable expenses: utilities, repairs & maintenance, management fees, payroll & benefits and other administrative costs. Furthermore each one of these line items can be discussed in even greater detail. For example utility expense can be broken into actual electricity, gas, water and sewer expenses. Repairs & Maintenance can be identified by trash removal costs, pest control, building repairs and maintenance, turnover/cleaning, supplies, HVAC maintenance, elevator maintenance, pool maintenance, parking lot maintenance and grounds/landscaping. Additionally, payroll costs can be identified by determining the office payroll, maintenance payroll, security payroll and any other expenses. Finally administrative expenses can be identified as employee/model units, advertising expenses and office expenses.
However the expenses have been identified from the borrower's income and expense statements it is the goal of the underwriter to consistently categorize the expenses so that the reader understands how much it actually costs to operate the property on a year to year basis.
Total operating expenses should be totaled and stated as a per square foot number based upon the square footage of the building or in the case of multifamily properties, stated as a per unit expense. Total operating expenses should be compared to the historical expenses and the appraiser's estimate. Increases and decreases based upon percentages should be explained. In all cases it is the goal of the underwriter to specifically identify recurring expenses and make a judgment as to the conclusion of the underwritten expenses.
Underwritten net operating income should be compared to historical levels and explanations should be given for increases and decreases from the previous years.
Finally, structural reserves, which have been recommended by the engineering reports, should be utilized in the spreadsheet. Tenant improvements and leasing commissions should be based upon the guidelines of the financial institution that is making the loan. Typically, a rollover analysis is performed which takes into account the expiration of the leases, an assumption of the tenant renewing the lease, the amount of tenant improvements required at the time of a new lease. Tenant improvements can range from a $1/SF for warehouse buildings to $20/SF for office buildings. Additionally leasing commissions stated as a percentage of the lease range from 2% to 6% and are utilized in the calculation of the rollover analysis. The rollover analysis should be considered a separate spreadsheet, by itself, for average tenant improvement and leasing commission amount based upon markets facts and market analysis as provided by the appraisal.
Finally the actual Cash Flow should be discussed and compared to the historical cash flow as well as the actual debt service coverage ratios, which should be compared to the appraiser's estimate and previous years including the year to date annualized numbers and/or the trailing 12 month analysis. Concluding the actual underwritten cash flow is the basis for the extension of credit.
Debt service coverages should range between 1.20 and higher based upon the type of property and the condition of the property. Loan to value ratios should conservatively range between 70% to 80%. The financial institution should establish these guidelines. These pricing guidelines should account for the risk of a particular type of property by evaluating the debt service coverage ratio and interest rate attributable to that type of property at that level of coverage.
Other aspects of the Income and Expense analysis should include a Sensitivity Analysis and a Balloon/Refinance Risk section. The Sensitivity Analysis discusses the break-even characteristics of the rental rates as they relate to increased vacancy and increased operating expenses. The Balloon Analysis projects the amount of the outstanding balance of the loan in ten years and the cash flow available to refinance the outstanding balance of the loan.
The establishment of the cash flow is the most important ingredient of the entire underwriting process. This will be the area that will be the most scrutinized by the rating agencies. It is important to quantify the conclusions and have logical and consistent methodology in arriving at the bottom line cash flow for all the loans in the portfolio.
VI. Review of the Third Party Technical Reports
The Engineering, Environmental and Appraisal Reports should be reviewed and summarized in a consistent manner. The inspector, date of inspection and summary of the report should be stated.
The summary of the engineering report should identify several aspects of the property. For example the estimate of the remaining useful life of the property should be stated, the replacement reserve analysis should be reviewed and incorporated into a spreadsheet, compliance with all applicable laws & regulations should be reviewed and summarized and a summary should be provided that concludes the subject property meets fire/safety codes and requirements. Any physical repairs or maintenance that needs to be completed prior to closing should be summarized as well.
The summary of the environmental report should conclude whatever environmental risk is associated with the subject property if any. Any risks or issues should be explained thoroughly and, if the Operations and Maintenance program is needed for existing concerns, a full explanation of the program should be outlined.
The third technical report to be reviewed is the appraisal. The appraisal company, date of valuation, appraisal value, loan to appraised value, appraiser's capitalization rate, discount rate should all be identified. The underwriter should either agree with the final values or summarize material differences.
VII. Borrower/Sponsorship Analysis
The last section of the Underwriter's narrative should discuss the borrowing entity, the sponsorship, and financial analysis of the key principals and include a commentary on the experience and management of commercial real estate properties.
A. The Borrowing Entity
The ownership of the borrowing entity should be identified. For example is it held by a general partnership, limited partnership, Limited Liability Company, corporation, or held by an individual. All partners' ownership interest should be identified. One of the secondary market requirements is that the borrowing entity be structure as a single asset entity. Credit reports on the borrowing entity and the key principal should be summarized. Additionally the existing payment history of the loan can be referenced and summarized at this point. For example has the borrower consistently made payments on a loan that will be refinanced?
The assets, liabilities and net worth of the borrowing entity need to be discussed as it relates to the subject property.
B. The Key Principals
The personal financial statements of the key principals can be summarized in a chart or table format. The names Dates of the financial statements, credit history, assets, liquid assets, real estate assets, liabilities, net worth can be identified for all the principals and related entities. Similar to the financial analysis for the borrowing entity, a personal financial statement analysis should be completed which encompasses a review of any commercial real estate properties, which the principals may own other than the subject property.
VII. Property Management
The name of the management company should be identified as well as the relationship to the borrowing entity. A discussion should include the number of years in business, number of properties under management and the experience level of the management staff. Other issues to be commented on would include the determination if a management agreement were in place, if there is a base management fee, are there provisions for assumptions/assignment and is there an incentive management fee.
Even though the majority of the loans in a commercial mortgage backed security pool are non-recourse, rating agencies continue to want as much information on the sponsor of the loan. The theory is that a sponsor with a higher net worth will be better off financially in a down turn economy than a individual whose net worth is made up of the subject property. This is a quality issue and will become more and more important in the years ahead.
VIII. Recommendation Section
The underwriters narrative can be concluded by emphasizing in bullet point format several positive aspects of the loan which can include a re-statement of the debt service coverage ratio, loan to value ratio and the key strengths as identified in the Executive Narrative Section.