Income Property Commercial Loan - General Underwriting Considerations
The "new" underwriting requirements require the lenders and borrowers to return to the fundamental five C's of credit: character; capacity; capital; collateral and condition. Potential borrowers should also expect intense scrutiny of their past performance and personal credit histories, which will likely play a major part in the lenders' decisions.
There are two baic categories of underwriting to consider. The first is the asset, which is the overall review of the subject property. The second category is credit, which is the overall ability to act as a secondary source of repayment. The strengths and weaknesses within both the asset and credit must be taken into consideration when evaluating financing objectives by the lender.
Unlike residential loans, commercial loan underwriting can greatly differ case by case. There are, however, certain basic ratios with every commercial loan.
Debt Service Coverage Ratio (DSCR) this is used to determine whether a property (or business) is able to cover the mortgage and all other expenses tied to a property. Usually lenders require that the property be cash flow positive (more income than expenses) and that there is some buffer room. Break even would be a 1.0 DSCR, or in other words income equals expenses. Most loan programs require a 1.2, DSCR or 20% - 30% more income than expenses on the property. For owner occupied businesses where there is no rental income, the requirement is usually much higher (2.0+ DSCR) because they are gauging the strength of the business as opposed to the property itself. DSCR can vary depending on loan size, interest rate and amortization.
The most important ratio to understand when making income property loans is the debt service coverage ratio. All lenders use them in calculating the amount they are willing to lend. It is defined as: DSCR = Net Operating Income (NOI) / Total Debt Service.
Loan-to-Value (LTV)
This is used to determine what percentage of the property is being financed. As opposed to residential programs where 100% (or sometimes 125%) financing is available, most commercial programs max out at 60% - 75% depending on property type. SBA programs can often go as high as 90% for qualifying properties (usually owner occupied businesses), but be prepared for red tape.
Net Operating Income (NOI)
This is used to determine the profitability of a property. In simple terms, NOI is calculated by subtracting expenses from the income. Usually the income is decreased by a vacancy factor that the lender feels is conservative. Depreciation and mortgage payments are not included as expenses in this calculation. But there are several theoretical expenses that may apply (such as tenant improvements, leasing commissions, etc.) NOI is also used to determine cash available for debt service by dividing NOI by the minimum DSCR. Divide by 12 for a maximum monthly payment.
The expenses are the most difficult to determine. If you want to use a "quick and dirty" calculation for Multi-Family Units 5 and up use 38 % of the Effective Income on smaller apartments from 5 to 12 units and 32% on larger apartment projects. For commercial income properties use 38% of the effective income. Property with triple net leases should estimate expenses at 12% of the effective income. Expenses on commercial property rely on the type of leases the tenants have. The different types of leases are "net" and "modified gross". Each type is dependent upon what expenses are paid by the borrower (modified gross) or tenant (net). In a net lease the reimbursed expenses may include; property taxes; property insurance; common area maintenance. The modified gross means that the tenant does not pay any of the above items.
Also keep in mind that many properties will be limited more in new loan size amount by the results of the DSCR. The DSCR generally has more of an impact than the LTV limits, Gross Rent Multiplier, the capitalization rate (cap rate) or by the modified IRR (modified internal rate of return).
DSCR further explained
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:
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Calculating the Debt Service Coverage Ratio - DSCR -
Here is a basic example of how a commercial mortgage lender calculates the DSCR for a commercial loan request. The lender holdbacks are included, remember these are not actual expenses, but they are deducted from the property's gross income for underwriting purposes. Example assumes a 75 unit property multifamily property.
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Gross Rents
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$1,000,000
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Other Income
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Total Annual Gross Income
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$1,000,000
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Less 5% Vacancy & Collection Loss
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$50,000
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________
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Effective Gross Income:
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$950,000
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Real Estate Taxes
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$15,000
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Property Insurance
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$5,000
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Repairs & Maintenance
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$5,000
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Pest Control
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$5,000
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Janitorial
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$5,000
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Utilities
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$5,000
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5% Off Site Management Reserve
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$50,000
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Replacement Reserves
$200 Per Unit @ 75 Units
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$15,000
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Total Operating Expenses:
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$105,000
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Net Operating Income (NOI)
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$845,000
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Now that we have calculated the NOI, we must calculate the total debt service for the property, or simply determine the loan payment consisting of only the principal and interest. We do not include the taxes and insurance as they are accounted for in the expenses of the property.
To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the commercial mortgage loan payment.
Commercial Loan Size: $10,000,000 First Mortgage
Interest Rate: 6.5%
Term: 30 Years
Annual Payments (Debt Service) = $758,475
Now we can calculate the DSCR:
DSCR = Net Operating Income (NOI) = $845,000
Total Debt Service $758,475
DSCR = 1.10
What this example tells us is that the cash flow generated by the property will cover the new commercial loan payment by 1.10x. This is generally lower than most commercial mortgage lenders require. Most lenders will require a minimum DSCR of 1.20x.
If a DSCR is 1.0x, this is called breakeven, and a DSCR below 1.0x would signal a net operating loss based on the proposed debt structure.
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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.
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 above when we arrived at net operating income (NOI).
To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the mortgage payment.
Note, you will notice we show management expense and reserve expenses above. Even if you don't pay those expenses, lenders will allocate industry standard percentages against the income for loan purposes.
Obviously the higher the DSCR, the more net operating income is available to service the debt. From a lenders viewpoint it should be clear that they want as high a DSCR as possible.
Most borrowers want as large a loan as possible. The larger the loan amount, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and or interest rate increase, therefore the debt service increases, which lower the DSCR.
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. Banks and mortgage banks generally only require a 1.20 - 1.25 DSCR, and sometimes will accept a DSCR as low as 1.10.
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