FAQ's Commercial Lending # 1

FAQs: Commercial Lending

What does "Loan-to-Value" (LTV) mean?
This is a ratio used by lenders to determine how much they will lend on a particular property. It encompasses the ratio of the loan amount to the value of the property. For example, let's say that an investor/borrower wants to purchase a property that is valued at $5,000,000. He/she pays $1,000,000 as a down payment, meaning this individual would be seeking a loan amount of $4,000,000. Thus our ratio of loan-to-value would be $4M/$5M, or 80%. Generally, a lender prefers to see an LTV no greater than 75%, but most will go higher if the quality of the property is exceptional and/or the borrower has a substantial net worth.


What is meant by a "point"?
When we are talking about financing, the term "point" essentially means percent. For example, one point on a one million-dollar loan is equal to $10,000, or 1% x $1,000,000.


What is a rate lock?
Borrowers do not want to be surprised at the close of the transaction with a rate which is higher than what was quoted at the beginning of the process. Hence, many borrowers ask that the lender commit or lock the initial rate that was quoted for the length of the loan. When a rate is locked, the lender is being asked to guarantee the price of a commodity, the price of which may change on a daily basis. (For example, check out the fluctuation of the bond market -- a daily measure of the price of money.) The longer the lock period, the riskier the position of the lender, hence the higher the loan price (points) charged the borrower.


What is meant by "capitalization rate"?
The capitalization rate, or "cap rate" as it is more commonly referred to, is a ratio used to estimate the value of a commercial real estate property.
In more general finance terms, according to the Appraisal Institute, it is a method used to convert an estimate of a single year's income expectancy into an indication of value in one direct step, by dividing the income estimate by an appropriate rate.
The relationship between Cap Rate (R), Income (I), and Estimated Value (V) is as follows:

V = I / R
I = V x R
R = I / V


What is "Debt Service Coverage Ratio" (DSCR)?
The final ratio that a lender will use when evaluating a commercial real estate or income-producing property is the debt service coverage ratio (DSCR). The debt service coverage ratio is a sophisticated ratio only used for large loans on commercial real estate and/or income-producing property.
The debt service coverage ratio is often used by loan officers when making loans to perspective income property loans.

A Closer Look at DSCR.
The most important ratio to understand when making income property loans is the debt service coverage ratio. It is defined as:
DSCR = Net Operating Income (NOI) / Total Debt Service
To understand the ratio it is first necessary to understand the numerator and the denominator. Let's take a look at net operating income (NOI) first.
Net operating income is the income from a rental property left over after paying all of the operating expenses:
Gross Scheduled Rents $100,000
Less 5% Vacancy & Collection Loss $5,000

Effective Gross Income: $95,000
Less Operating Expenses
Real Estate Taxes
Insurance
Repairs & Maintenance
Utilities
Management
Reserves for Replacement
Total Operating Expenses: $30,000

Net Operating Income (NOI) $65,000

Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate in an area to cover collection loss. In addition, lenders always insist on using a management factor of 3-6% of effective gross income, even if the property is owner-managed. Their logic is that they would have to pay for management if they took back the property. Finally, NOTE THAT WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.

Next let's look at the denominator, Total Debt Service. This includes the principal and interest payments of all loans on the property, not just the first mortgage. NOTE THAT WE HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted for when we arrived at the net operating income (NOI).
To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139

Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14
Obviously the higher the DSCR, the more net operating income is available to service the debt. From a lender's viewpoint it should be clear that they want as high a DSCR as possible.
The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.
Life insurance companies are very conservative and generally require a 1.25 or 1.35 DSCR. This means that their loan-to-value ratios are low. Savings and loans (S&L's) generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.
A DSCR of 1.0 is called a breakeven cash flow. That is because the net operating income (NOI) is just enough to cover the mortgage payments (debt service).
A DSCR of less than 1.0 would be a situation where there would actually be a negative cash flow. A DSCR of say .95 would mean that there is only enough net operating income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to keep the project afloat.
Generally lenders frown on a negative cash flow. Some lenders will allow a negative cash flow if the loan-to-value ratio is less than around 65%, the borrower has strong outside income such as an electronic engineer, and the size of the negative is small. Lenders rarely allow negative cash flows on loans over $200,000.