OVERVIEW OF THE LOAN PROCESS

OVERVIEW OF THE LOAN PROCESS

Originating a new loan begins when a prospective borrower contacts an MLB or lender representative now also
referred to as a mortgage loan originator (MLO). The MLO should be prepared to listen to the applicant’s

needs, gather appropriate information and respond to the inquiry with accurate program descriptions that would
be best suited to the applicant, the consumer/borrower. Preparing for inquiries in advance will enable the MLO
to handle the inquiries in a logical and uniform manner.

Whether the loan will be delivered to a depository institution, to a non-bank (including licensed
creditors/lenders), or to private investors/lenders; the MLO should know the details of each loan program
offered as well as the guidelines, policies and procedures of the funding sources with respect to originating
residential mortgage loans. The MLO’s ability to obtain comprehensive information up front will result in the
best service to both the applicant and to prospective lenders or permanent investors.

There are four steps to originating a real estate loan:

1. The Application;

2. Loan Processing;

3. Underwriting Analysis; and,

4. Loan Approval, Funding and Closing.

The Application

The application form is a summary of all key components required by a lender or permanent investor to
determine if an applicant qualifies for the loan request, has the ability to repay the loan, and whether collateral
sufficient to support the debt/loan will be provided by the borrower. The loan application is to be completed
with the assistance of a representative of the lender or the MLB (as previously mentioned, each is also known
as MLOs). The application is to be completed accurately and entirely to facilitate processing, underwriting,
funding and closing the requested loan.

Historically, application forms varied from lender to lender. Now, a “standard” form for residential mortgage
loan applications is commonly used in the mortgage lending and brokerage industries. The form is a
collaborative effort between FNMA and FHLMC. Each agency has assigned a different number to the same
form; the FNMA Form is 1003 and the FHLMC Form is 65. The application form most often referred is the
FNMA 1003. Today, even FHA and VA use this form.

An initial interview with the prospective borrower is necessary, whether occurring telephonically,
electronically, or in person (face-to-face). The interview provides MLOs with the opportunity to make certain
the applicants understand the terms of the loan requested, among other important issues within the loan process.
The requirements of the lender to whom the loan application is or will be submitted will often control how the
initial interview is to occur. Interviews with the prospective consumer/borrower are necessary to complete
accurately the loan application package.

The proposed loan request is normally set forth in writing on the 1003. It identifies the amount and proposed
terms of the requested loan, the purpose of the loan, and how and when the loan is to be repaid. Each loan
request is to be evaluated in a fair, impartial, and non-discriminatory manner.

The Federal Equal Credit Opportunity Act (ECOA) prohibits discrimination based on age, sex, race, marital
status, color, religion, national origin, receipt of public assistance, or that the applicants (consumers/borrowers)
have, in good faith, exercised any right under the Consumer Credit Protection Act. In addition under the Fair
Housing Act, discrimination is prohibited based on the existence of a handicap or on familial status, e.g., the
age and presence of children, except when the housing qualifies under HUD standards as senior housing. Each
person’s character and capacity must be considered fairly and equitably based on income adequacy; satisfactory
net worth, financial standing and management; job stability; on an acceptable credit rating, and on other
pertinent factors that are not unlawfully discriminatory. Credit guidelines are to be applied to each potential
consumer/borrower in an equal manner, including the income of each spouse.

Advance Fees

MLOs who are MLBs as well as lenders may wish to collect money in advance from a loan applicant to cover
the cost of services to be performed in arranging or originating the mortgage loan. Money collected “up front”
is an advance fee. Advance fees are defined in and subject to the regulation of the Real Estate Commissioner
pursuant to Business and Professions Code Sections 10026, 10085, 10085.5, 10131.2 and 10146. Fees imposed

at the time of the loan application are also subject to the requirements imposed under the Real Estate Settlement
Procedures Act (RESPA) that is discussed later in this Chapter (12 USC Section 2601 et seq. and 24 CFR
Section 3500 et seq.).

Unless the advanced fee is for a credit or appraisal report and is in the exact amount required by the service
providers, an MLB/MLO may only collect an advance fee pursuant to a written agreement previously reviewed
and authorized by the Department of Real Estate (DRE). Real Estate Commissioner’s Regulation 2970 sets
forth the basic contents of an advance fee agreement. The MLB must also submit for the DRE’s prior approval,
advertising materials used in conjunction with an advance fee arrangement. Additionally, the verified
accountings and trust fund handling as required by Business and Professions Code Section 10146 and set forth
in Commissioner’s Regulation 2972 must be reviewed for and to establish the appropriate policies and
procedures to maintain the MLB’s/MLO’s books and records in compliance with the foregoing.

Any real estate broker or MLB who contracts for or collects advance fees from a principal must deposit the
funds into a properly constructed trust account. Advance fees are not the broker’s/MLB’s funds. Amounts may
be withdrawn for the benefit of the broker/MLB only when actually expended for the benefit of the principal or
five days after verified accounts have been mailed to the principal for whom the fees are being held. If advance
fees are not handled in accordance with the Real Estate Law, it will be presumed that the broker/MLB has
violated Penal Code Sections 506 and 506a (i.e., embezzlement and conversion). Penalties, fines and jail or
prison terms may result.

As previously mentioned, the DRE permits by policy MLBs/MLOs to collect fees in advance for appraisal and
credit reports as long as the broker collects as near as possible the exact amount(s) necessary and deposits these
funds into a properly constructed trust account. Refunds of any excess to the principal are required as soon as
the excess is identified. Though credit and appraisal report fees are not treated as advance fees for the purposes
of prior approval of the DRE (as defined above), these funds are trust funds. On October 11, 2009, Governor
Schwarzenegger signed Senate Bill 94 (Calderon), and the legislation took effect immediately upon his
signature. California law prohibits any person, including real estate licensees and attorneys, from demanding or
collecting an advance fee from a consumer for loan modification or mortgage loan forbearance services
affecting 1-4 unit residential dwellings.

Loan Processing

Once the application is complete with the assistance of an MLB/MLO, the applicant will be given a list of items
that will comprise a loan application package. In addition, certain disclosures to the applicant
(consumer/borrower) are required. Disclosures and notices of rights will be addressed later in this Chapter.

The MLB/MLO will usually submit the application to loan processing to assemble a loan application package.
A loan application package consists of a properly completed application form and the supporting
documentation required to process the loan and to make a credit decision. During the loan process, the lender
typically uses a series of checklists to ensure each of the required steps properly occurred and the necessary
documentation and support information has been gathered to approve and to close the loan requested (the loan
for which the applicants applied). The loan processing checklists often include:

1. A Compliance Checklist;

2. A Stack Order;

3. A Borrower Checklist; and,

4. A Property Checklist.

Borrower Information

The following information is gathered by the processor and helps the lender to assess their risk by
understanding the borrower’s capacity/ability and willingness/desire to repay the loan:

1. Purpose of the loan. Learning why the applicant (consumer/borrower) wants to borrow money and the
use of the loan funds will help to determine the risk associated with the extension of credit. The loan
purpose will categorize the loan requested to determine the program criteria and what disclosures are
required. The three common categories of loan purpose include (a) purchase, either for occupancy or

investment; (b) refinance, either to obtain a better loan rate and terms, or to receive a “cash-out”; or (c)
an equity loan to obtain financing for home improvement or other described financial needs or
objectives.

2. Source of Repayment. Typically, the primary source of repayment will be from the combined income
received through the employment or professional activities of the applicants. Determining the type of
business or profession pursued by or the employment of the applicants, how long the applicants have
been in business or have engaged in a defined professional activity or how long employed in acurrent
or related job in the same industry, will help to establish the stability of the income. Most lenders look
for a minimum of 2 years in the same line of work or professional pursuit. In some instances, the
source of income is through self-employment, from either a business or professional activity.

3. The applicant (consumer/borrower) may also present investment income as the source of repayment.
In such instances, support documentation will prove to be critical in this analysis. The underwriting
lender will look at the applicants’ historical income and longevity of employment; the future expected
trends of the employment, business, or profession of the applicant; and whether there is a likelihood of
continuance in the same employment, business, or professional activity.

4. Assets. The asset breakdown represents the strength and composition of the financial standing of the
applicants. Liquidity is important to determine the applicants’ ability to provide down payment funds
and required cash reserves, as well as to overcome unforeseen interruptions in income or irregular
expense items. It is also an indication of the applicants’ ability to save. Equity in other real estate,
businesses, investments, or insurance policies also serves to demonstrate the applicants’ overall
substance.

5. Liabilities. Liabilities represent the applicants’ leverage/debt against assets and the financial
obligations that result in monthly payments, referred to as expenses. These expenses are usually
broken into two categories, defined as the monthly housing expenses to establish a “front-end” ratio of
debt to income, and the total monthly obligations to establish a “back-end” ratio of debt to income.
The monthly housing expenses include the required monthly loan debt service, the debt service on any
other financing against the security property, property taxes, assessments, causality and hazard
insurance premiums, mortgage insurance premiums, and the dues or assessments of homeowners
associations. The total monthly obligations include housing expenses and additional monthly debt
service such as long-term contractual installment debt (vehicle or furniture payments), revolving debt
such as credit card payments and open accounts, spousal and child support, and other liabilities that
require monthly payments. The foregoing currently does not include when underwriting conventional
loans or alternative mortgages or non-traditional loan products, utilities or the maintenance of the
property (unless the loan product is FHA insured or VA indemnified).

6. Credit History. Each lender sets general policy guidelines outlining acceptable credit quality. These
policies typically include loan terms that are predicated on different credit score thresholds. Credit
policies are influenced by the lender’s intent to keep the loan in their portfolio or to sell the loan in the
secondary marketplace. Whether the lender relies solely on a credit score or on the overall repayment
habits of the applicants, the credit history is a good indication of the applicants’ financial management
and how the prospective mortgage loan will be repaid, given a continuance of represented income. A
lender may favorably consider repeat consumers/borrowers who have a proven “track record” of
repayment or other banking or loan relationships with the lender.

Property Information

The value, condition of title, and overall quality of the property is evaluated to ensure the collateral will be
adequate to secure repayment of the loan. Because of the long terms associated with real estate loans, the lender
will estimate not only the current value and condition of the intended security property, but the economic trends
in the neighborhood and community where the property is located. To further this evaluation, the loan
processor will order the following reports:

1. Preliminary “Title” Report. A primary concern is that the consumer/borrower has good title to the real
property which would secure the loan. Once a lender decides that serious consideration can be given to

a loan application, a preliminary report will be obtained on the proposed security property from a title
company or from the intended title insurer to describe the terms of the offer to insure title to the
property.

The purpose of a preliminary report is to:

a. Identify the property, including assessor’s parcel number, street address, legal description and
any issue that may be presented by the legal description;

b. Identify the current vesting (owner of record); and,

c. Reveal proposed title policy exceptions, including property taxes, assessments, encumbrances,
liens, easements, claims and conditions of record, etc.

When all objections to title are resolved to the satisfaction of the lender, a title policy insuring the interest
of the lender must ordinarily be obtained at the time the loan is funded. In this policy, the title insurer
agrees to defend and indemnify the lender against damages/losses suffered by the lender arising from
actions founded upon claims of encumbrances or title defects which were known, or should have been
discovered, by the title insurer when the policy was issued.

2. Appraisal. A staff or independent fee appraiser will be engaged to inspect the property and estimate
present market value and future value trends. The relationship between the amount of the proposed
loan and the estimate of fair market value of the intended security property is the “Loan-to-Value”
ratio. Most lenders base their loan amounts on the purchase price or appraised value, whichever is
less.

The purpose of the appraisal report is to ascertain:

a. An estimate of the current market value of the intended security property;

b. Description and condition of land and improvements;

c. Applicable zoning and if the current uses of the land and improvements are consistent with the
zoning;

d. Neighborhood and community market conditions;

e. Any discernable issues with the legal and physical description of the intended security
property; and,

f. The nature of the occupancy.

3. Property due diligence. Depending upon the fact situation, the following property issues may also
be addressed:

a. If other than the borrower, the status of and whether the occupant is asserting a title claim;

b. If a loan is to finance the purchase of the proposed security property, the sales price and
proposed terms;

c. If a refinance, the date of original purchase, the price and terms of such purchase;

d. Are there additional assessments (regular or special);

e. If income producing property, the historical and projected operating income and expenses,
and the amount of expected net operating income available to support the mortgage loan debt
service; and,

f. Has any work occurred on or related to the security property within the last 90 days that
might result in a mechanics’ lien or other title claim.

Once up front disclosures are provided, the applicant has supplied all requested support documentation, and the
credit, prelim and appraisal reports have been received, among any other items requested by the lender; the loan
file should contain enough information to be presented to an underwriter. The application package should be
organized in a logical manner using application and processing checklists to ensure conformity and compliance
with the lender’s policies and procedures.

Construction and Rehabilitation Loan Requests

In addition to the elements of loan processing for loan transactions where the intended security property is
improved residential or commercial, as defined, vertical construction loan transactions require the gathering of
additional documentation to support the loan request.

The following list is included to illustrate the documents and information to be gathered for vertical
construction loans. Many of the items on the list will also apply to land acquisition and development loans
whether residential, income producing or other forms of commercial property:

1. Current Preliminary Report meeting the requirements of the intended lender or permanent investor
regarding the date of issuance and subsequent “date down” showing the condition of and the claims
against title (including conditions, covenants, restrictions, encumbrances, liens, etc.);

2. Land Survey, if applicable or required for ALTA extended coverage, showing the exact location of the
security property and the improvements thereon, or a proper final tract map or parcel map (if a
subdivision) in accordance with the Subdivision Map Act;

3. Soils Report, if obtained, showing the composition and condition of the soil and sub-soil, topography,
flood, and landslide or soil subsidence hazards, or related existing conditions, etc. (including whether
the report is generic to a subdivision or site specific);

4. Geologic Hazard Report, if applicable, showing any known geologic or seismic hazards including
historic landslides which may affect the intended security property;

5. Environmental Impact Report or Negative Declaration as required by the governmental agencies
having jurisdiction over the matter;

6. If the financing contemplated is to be secured by a junior encumbrance in a context of a subdivision or
contiguous phases or units in the same subdivision, whether the financing is subject to the
requirements imposed for promotional notes pursuant to the Securities Law;

7. Contractor’s resume and qualifications, and the contract for new construction showing a cost
breakdown and description of materials, building plans and specifications as approved by the local
government of jurisdiction, etc.;

8. Contracts from design professionals and bids from the major subcontractors intended to be engaged
for the project;

9. Approvals from local and regional governments, districts or commissions having jurisdiction over the
project, e.g. Coastal Commission;

10. Appraisal report in a form appropriate for the transaction, including an estimate of the market value of
the intended security property “as is” and “as completed” applying a discounted cash flow or an
anticipated development analysis with absorption rates and estimating costs for holding periods when
appropriate, in accordance with USPAP;

11. Evidence of compliance with the Subdivided Lands Law if the project is a CID subject to the issuance
of a Public Report and of the financial arrangements and bonding to ensure lien free completion in
accordance with the requirements imposed by local governments and the DRE; and,

12. Insurance policies extending coverage for course of construction, general liability and workers
compensation, among others, including proper endorsements.

The above list is intended to be illustrative and not comprehensive. The documents and information to be
gathered will vary substantially depending on the nature of the land development or vertical construction to be
financed. Loan documents/instruments evidencing and securing land development or construction loans are
unique and include construction loan and security agreements; UCC-1 filings; assignments of contracts with
contractors, subcontractors and design professionals; assignments of plans, specifications, and building permits,
among many others. These transactional loan documents/instruments, agreements, disclosures, etc., should be
reviewed by knowledgeable legal counsel before proceeding with land development or vertical construction
loans.

Loan Processing Wrap Up

When the loan is packaged by an MLB, the broker’s file should be maintained in a logical manner consistent
with the practices of the broker (MLB) recognizing the policies and procedures of the lender to whom the loan
is to be delivered. The lender or the authorized agent of the lender can then underwrite a properly developed
loan package.

Underwriting Analyses

The underwriter’s role is to assess the risk of the proposed loan and make recommendations whether to approve
the loan. In addition, the underwriter will ensure the loan package is in compliance with not only applicable
laws but with the lender’s policies. The underwriter will typically use an underwriting checklist to make sure all
components, elements, and conditions are considered and/or included, and that a credit memo or other written
summary of verified information, recommendations, and conclusions of the underwriter will be completed.

The underwriter will carefully consider the ability/capacity and willingness/desire of the consumer/borrower to
repay the loan as well as the adequacy of the collateral. This analysis is based on:

1. Information contained in the loan application and supporting documents;

2. Information developed by the lender in checking the credit and character of the prospective
consumer/borrower;

3. Verification of employment, bank deposits, etc. of the consumer/borrower;

4. A review of the information obtained in the preliminary “title” and appraisal reports and from the
property due diligence;

5. A interview with the consumer/borrower either telephonically or in person; and,

6. A review of the specific loan file to ensure compliance with the lender’s policies and procedures,
including the loan product being offered to the consumer/borrower.

Lenders evaluate residential loan requests using various measures to answer two basic questions concerning the
consumer/borrower. What is the borrower’s capacity for repaying the loan? What is the borrower’s
willingness/desire to repay the loan? The first issue deals with the capacity to repay and involves calculating
debt ratios. The traditional secondary mortgage market (primarily represented by Fannie Mae and Freddie Mac)
dictated standard underwriting ratios of 28% and 36%.

The first number of 28% is the historic “front-end” ratio that was often ignored when underwriting alternative
mortgages or non-traditional loan products. As previously indicated, the borrower’s housing expenses include,
principal and interest payments on senior and junior encumbrances, property taxes, and homeowners insurance
premiums, collectively referred to as PITI. If the property is located within a common interest development
(CID), many lenders add on to the housing expenses the dues/assessments imposed by the homeowners
association (HOA). The relationship between total housing expenses and the borrower’s gross monthly
income is translated into a ratio with the housing expenses not to exceed 28% of the gross monthly income, i.e.,

the “front-end” ratio. In restructuring existing mortgage loan/debt, an acceptable “front-end” ratio is as much as
38% of the borrower’s gross monthly income.

The second traditional number of 36% is the historic “back-end” ratio that was also often ignored when
underwriting alternative mortgages or non-traditional loan products. As previously indicated, the borrower’s
total monthly obligations include, the aforementioned housing expenses, as well as any other long-term
installment debt (defined as obligations that have more than 10 months of payments remaining before they are
paid off); certain forms of revolving debt such as credit cards and open account payments; spousal or child
support; and other qualifying liabilities subject to monthly debt service. The historic relationship between the
total housing expenses plus other qualifying monthly obligations was translated into a ratio not to exceed 36%
of the borrower’s gross monthly income.

Fannie Mae as part of revamping their underwriting guidelines has since abandoned the above described
housing ratios in favor of a total debt ratio, now called the benchmark ratio of from 36% to 38%, depending
upon the fact situation. It is important to understand the 36% to 38% benchmark ratio is a guideline only which
is considered in conjunction with other factors as part of a comprehensive risk assessment. An incremental
increase in the ratio above 36% to 38% may not be considered significant in the overall decision. Underwriting
guidelines currently consider a low or high ratio as a contributory risk factor that may decrease overall risk
when the ratio is less than 30%, or increase the overall risk when the ratio is over 42%. Part of the risk analysis
is the consideration of the net available income to service the consumer/borrower’s general obligations and
living expenses including income taxes, food, utilities, transportation, etc.

The credit report is the means the lender uses to measure the borrower’s willingness/desire to repay.
Traditionally, lenders evaluated a borrower’s credit by doing a line-by-line analysis of each “tradeline” or
source of credit appearing on the consumer/borrower’s credit report. This often resulted in a level of scrutiny
which required consumers/borrowers to provide additional loan documentation by way of a letter to explain,
“why they were late once on a department store credit card four years ago”. This was true even though it may
have had little relevance in predicting risk for the current credit decision.

Today, most lenders rely on credit scores to summarize a consumer/borrower’s credit profile with respect to its
overall predictability of future delinquency risk. Even with the use of credit scores which have become
commonplace, specific issues may result in the requirement for a letter of explanation. For example, a past
record that includes a Notice of Default, a bankruptcy, or an action by a creditor/lender to obtain a judgment for
non-payment of a debt will likely result in a letter of explanation (See additional discussion of credit scores
under Fannie Mae’s Automated Underwriting).

Fannie Mae’s Automated Underwriting

Fannie Mae has automated the underwriting process for lenders through its Desktop Underwriter (DU)
program. DU is a knowledge based software tool that contains rules for the quantitative assessment of risk
associated with a given loan request. It not only provides a comprehensive risk assessment of the borrower’s
capacity and willingness/desire to repay a loan, but also determines whether the loan meets the eligibility
criteria for purchase by Fannie Mae.

MLBs/MLOs through Desktop Originator (DO) are able to access the DU to deliver point of sale underwriting
decisions for the consumers/borrowers who are their clients. This results in greater efficiencies for lenders and
MLBs. In addition, the immediate feedback enables the MLB/MLO and the consumer/borrower to utilize “what
if scenarios” in putting together a structured loan program that is the most suitable for the client while at the
same time pursuing the objective of loan approval.

Automated underwriting initiatives rely heavily on credit scores generated from each of the three national
repositories of credit data: Experian, Transunion, and Equifax. Credit scores are derived from statistical models
applying complex mathematical formulas to evaluate the raw credit data in a consumer/borrower’s file to
predict the desired repayment of the loan being requested. These three digit scores generally range from 300 –
850 with the higher the score representing the lesser risk. The borrower should ask the MLB or MLO to whom
they are applying about credit practices the borrower should avoid that could result in an inadvertent decline in
the reported credit score.

The historic statistical analysis has suggested that one out of every 39 consumers with a score from 660–679
(considered a fair or acceptable score for many loan programs) will become 90 days or more late on a loan. A
score of 700 or higher is considered a very good score and will generally qualify a consumer/borrower for most
loan programs. The general benchmarks used by lenders for credit scores are 620, 650 and 680. A credit score
of less than 650 issued to a borrower will likely result in a higher interest rate. Conversely, a credit score in
excess of 680 will likely result in a preferential lower interest rate.

Freddie Mac offers an automated loan-underwriting program called Loan Prospector (LP). It operates in a
similar manner to the Fannie Mae automated underwriting system and relies, as well, on credit scores generated
from each of the three national repositories of credit data. Freddie Mac also uses similar credit score
benchmarks which are applied in the same manner.

Underwriting Income Property

There are different methods of underwriting income property. The methodology is often dependent on the type
of loan request and the primary source of repayment. For example, if the loan is secured by a rented or leased
fee commercial investment property (such as an apartment building, retail store, or an office building), the
lender likely will rely heavily on the security property’s cash flow that is available to service the mortgage debt.
Since the income from the security property will be the primary source of repayment, the lender will ask to
review rental and lease agreements and for lessee estoppel certificates to be obtained.

In the case of an apartment property, the rent roll and the status of the rent on each unit are included in the
information required to underwrite the loan. Secondary sources of repayment may come from the borrower’s
excess cash flow or liquidity (depending on if the loan is recourse or non-recourse). The tertiary source of
repayment may come from the sale of the security property. In this method of underwriting, a debt coverage
ratio will be established. Generally, the underwriter determines the debt coverage ratio by using the following
formula:

Plus Projected Gross Rents Other Income (Economic or projected gross rent scenarios will be considered) (e.g., laundry, parking, common area maintenance reimbursements)
Equals Total Gross Income ( Economic or projected)
Less Equals Vacancy Factor Effective Gross (Includes projected vacancies, collection, and credit losses)
Less Operating Expenses (Economic or projected)
Equals Net Operating Income (Economic or projected)

The projected gross rents estimate the income the security property should generate if rented at economic or the
then current market rents. If long-term leases encumber the security property with contract rents that are less
than economic or the then current market rents, the market value of the intended security property is burdened
by these actual rents. The available income stream upon which to rely for a debt coverage ratio is reduced by
the contract rents from the long-term leases. The actual gross income from the contract (actual) rents will
correspondingly reduce the available economic or projected net operating income (NOI), i.e., the actual NOI
will be less than the economic or projected NOI. The actual NOI will prevail when calculating the debt
coverage ratio.

The NOI is the cash flow of the property and the amount available to service the mortgage debt. The debt
coverage ratio (DCR) is determined by dividing the annual NOI by the annual mortgage debt service. The debt
coverage ratio will vary depending on the loan, property type, and the creditor/lender or the permanent investor.
For example, an institutional lender making a loan on an apartment building may require a 1:15:1.0 DCR. This
means that for every dollar of debt service, there must be $1.15 of NOI. In a commercial loan transaction where
the intended security property is other than an apartment building and the underwriter believes the loan
represents a greater risk to the creditor/lender or to the permanent investor, the lender may ask for a 1.25:1.0
DCR.

If the loan is a recourse transaction or there is a third party guarantor, the financials of the borrower and the
guarantor will be evaluated to determine their overall financial strength. The objective is to estimate the
financial ability to service any shortfalls, should the security property’s income stream be interrupted.

In the case of income property that is occupied by an owner/user (such as an industrial building where the
borrower’s business is located) another underwriting method may be used. In this instance, the primary source
of repayment is from the borrower’s business. Accordingly, a global cash flow analysis will be considered
encompassing not only the income of the business, but also income from other sources the borrower may have.
The available cash flow is compared to the expenses of the business as well as to any personal debt/loans of the
borrower. The lender will also consider the continued viability of the business as a “going concern”. This
analysis of the business is an essential element in the qualification for a loan to be insured by the Small
Business Administration (SBA).

Further, if the loan is a non-recourse transaction secured by a single-tenant building (such as a fast food
restaurant), the strength of the tenant, the ability to produce sufficient cash flow to support the mortgage debt
service, and the continued long-term viability of the business as a “going concern” will be evaluated by the
underwriter.

In addition, when evaluating an investment grade commercial loan transaction, the tools of analysis used may
include an inquiry into four main categories:

1. Liquidity. One component of the borrower’s assets is their liquidity. The borrower’s liquidity includes
cash and cash equivalents that are available for down payment, liquid reserves, and in some cases from
additional collateral. An underwriter must consider how able a borrower is to pay bills as they come
due. Current assets are compared to current liabilities. A liquidity ratio of 2 to 1 or better (current
assets are twice the liabilities) is recognized as acceptable by most lenders. Cash on hand and accounts
and notes receivable due within one year are considered “current assets”; debts and obligations due or
payable within one year are considered “current liabilities.”

2. Leverage. This is the ability of the borrower to control a large investment with a small amount of his
or her own equity capital and a large amount of other people’s money (the use of leverage). The more
money borrowed in relation to the value of the security property, the greater the leverage. Leverage
tests reveal how much of the total financing for the project is supplied by the owner and how much is
supplied by creditors such as the mortgage lender.

Included in the leverage analysis is a consideration of the “debt-to-equity ratio”. Leverage tests in
connection with analysis of a borrower’s financial statements are completed by comparing the
borrower’s equity interest in the assets owned and the total value of the capital investment to the long-
term debt. The purpose is to find how much of the total investment is ownership and how much is
debt. In a purchase transaction, to determine the original equity ratio, the down payment is divided by
the purchase price; and to determine the original debt ratio, the loan amount is divided by the purchase
price.

It is common for equity investors to seek debt ratios in excess of 75-80%. However, the ability to
exceed this ratio is often capped by applicable regulatory law. Lenders, looking at risk factors,
carefully scrutinize loan proposals to assure a safe equity ratio based on property characteristics and
the borrower’s repayment record. The rule of thumb for debt to equity ratio will be something between
3:1 and 4:1. The borrower often wants a more extreme ratio, because it reduces the amount of equity
capital that is at risk in the transaction. Real estate investment examples in a liquid money market have
been presented where ratios of 1 to almost zero are achieved by borrowers. This is usually a very
dangerous situation for the lender and is not available in a highly regulated atmosphere. An exception
allowing for zero debt to equity ratio is when the repayment of the loan is guaranteed or insured by
some reputable third party in the transaction, e.g., the United States Department of Agriculture
(USDA), or a financially strong company such as a major chain store or oil company.

Some lenders are willing to risk entering a high debt to equity loan situation in anticipation of market
prices going up, which automatically achieves growth in the owner’s equity resulting a more moderate
ratio through property appreciation. History has repeatedly shown that the expectation of market
appreciation is uncertain, especially in unstable economic conditions where a flat or down market
often occurs.

Coverage of fixed expenses is a test of how many times net income before income taxes and fixed
expenses (gross income minus operating expenses) will cover the fixed expenses. It reveals how far
the income can drop before the security property (or the borrower) will be unable to meet the fixed
expenses such as real estate taxes, insurance, license and permit fees. Net operating income after
operating expenses is divided by fixed expenses to get this ratio. If the ratio is 1:1, the net operating
income after operating expenses is just barely able to cover the fixed expenses. This is known as the
break-even ratio.

3. Activity. Activity tests are designed to reveal just how hard and effectively assets are working. There
are several tests for this but the most widely used is the income to total asset ratio. This ratio is found
by dividing total income by the value of the total assets.

4. Profitability. Profitability tests are designed to see how much net profit results from the operation. The
following are several of a variety of ratios and tests that are used to inquire into profitability.

Included is the “return on net worth.” This is the ratio of net profit (after taxes) to the net worth of the
project. This will yield a percentage return on investment which can be compared with the return
available from other investments of comparable risk. This is known as the alternative investment
theory.

Another profitability test is “yield analysis”. This form of analysis is well suited to estimating
profitability of real estate projects because it is relatively easy to compute and takes into consideration
three factors unique in their combination to real estate investment: cash return, equity return, and tax
shelter. It involves dividing the total return (net spendable cash income, principal reduction of
mortgage loans, and tax shelter) by the borrower’s equity. This is referred to as the internal rate of
return (IRR).

Loan Approval, Funding and Closing

Lender’s Action

Most lenders operate with a Loan Committee of experienced senior officers who consider loan applications
recommended to them by loan officers or borrower representatives (MLBs/MLOs). These MLOs have
screened the applications through borrower interviews including due diligence about the borrower and the
intended security property. The due diligence includes obtaining appraisal reports and other applicable reports
such as credit data. The underwriting analysis will typically represent the summary of the due diligence
accomplished regarding the borrower and the intended security property.

Through the underwriting analysis, the loan request will be approved, declined or the file may be closed for
incompleteness. The file is closed if the applicants have failed to provide required documentation and support
information. If the loan request and application is approved, the file progresses to the Loan Funding/Closing
Department for document/instrument preparation, funding of the loan, and ultimate closing of the loan
transaction.

Funding and Closing of the Loan

Depending upon how the lender is organized, the Loan Funding/Closing Department or the Document
Preparation Department will (subsequent to loan approval) prepare and complete the documents and
instruments required to evidence and secure the intended loan as well as the federal and state disclosures and
notices of rights to which the borrower is entitled. A loan closing and funding checklist will be added to the file
to ensure all appropriate documents/instruments are included. In addition, lender’s escrow instructions will be
prepared and transmitted with the documents, instruments, disclosures, and notices of rights to the escrow
holder for the signature of the borrowers.

The mechanics of closing the loan will vary. For the sale of a residence, an escrow holder is usually handling a
sale transaction between the seller and buyer and a loan transaction between the lender and the buyer/borrower.
In a loan transaction where no sale is involved (i.e., a refinance or further encumbrance of the security
property), the escrow holder’s assignment will be limited to escrowing the intended loan as well as obtaining

the signatures of the borrowers on the loan documents, instruments, disclosures, notices of rights and escrow
instructions necessary to close the loan transaction.

The escrow holder will typically furnish the lender with a certified copy of the signed escrow instructions,
together with any amendments thereto, and other documents, instruments the lender may require. As indicated,
an escrow officer employed by the escrow holder should obtain the signatures of the borrower on the required
documents, instruments, instructions, disclosures and notices of rights as directed by the lender. This activity
should not be delegated to independent signing agents without the express authority of the lender. MLBs/MLOs
are not authorized under the Real Estate Law to participate in the delegation of this function to independent
signing agents to carry out the obligations imposed under the Real Estate Law and pursuant to the exemption
available under the Financial Code when the broker is acting as the escrow holder (Business and Professions
Code Section 10133.1(c)(1) and (c)(2) and 10 CCR, Chapter 6, Section 2841; and Financial Code Section
17006(a) and (b)).

The escrow holder returns the loan documents and certified copies of the instruments to be recorded to the
lender for final review and approval in advance of loan funding. The escrow holder then awaits confirmation
that the lender is ready to fund the loan and for the receipt of the loan funds to close the loan escrow.

Recordation

When the lender’s instructions have been complied with, no conflicts remain or exist in the instructions of the
principals, and the lender approves the documents, instruments, agreement, disclosures, etc., as executed; the
lender sends/wires the loan funds to escrow. Upon receipt and verification of the loan funds, the escrow holder
transmits or causes to be transmitted to the county recorder for recordation the appropriate instruments
conveying or encumbering the title to the security property as instructed by the principals of the escrow. The
escrow holder confirms the recording and then proceeds to order the requested title insurance coverage.

Subsequent to recordation and close of the loan escrow, the escrow holder distributes the loan documents,
instruments, agreements, disclosures, etc., pursuant to the instructions of the principals of the escrow that were
not otherwise previously delivered. Loan funds are disbursed in accordance with the foregoing instructions.