Lenders want to minimize risk when they make a loan. There are two former ways a lender manages their risk exposure when financing commercial real estate (Cre). The first way is to be sure that the loan they make is at an estimate that is less than the store value of a property if it should be forced to be sold. They want to be comfortable with the loan to value ratio Ltv.
The second way the lender manages risk is to be positive that the Net Operating income (Noi) of the property is greater than the estimate of the every year payments the borrower is obligated to make on the loan, leaving the borrower with cash flow that is not committed to loan payments. They want to comfortable with the debt assistance coverage ratio Dcr or Dscr.
Net Operating income (Noi) The Noi is the most leading estimate the lender looks at in the loan underwriting process. The Noi will be used to determine the value of the property and to determine the maximum estimate of payments a borrower can commit to when signing the loan documents. The Noi of a property is calculated by determining the property's first year Gross Operating Income and then subtracting the Operating Expenses for the first year. Gross Operating income - Operating Expenses =Net Operating Income
The Gross Operating income of property is the total income a property can expect to receive from all sources over a one year period. The Operating Expenses are the expenditures needed to keep the property operating during the one year same period.
Sample Calculation: 400,000 Gross Operating income 0,000 Operating Expenses 0,000 Net Operating Income
Loan To Value Ratio (Ltv) Lenders use Ltv to institute the maximum loan estimate a property will qualify for so that the lender could sell the property swiftly and recover their venture if necessary. First, the lenders determine the value of the property by using a version of the Capitalization Rate (Cap Rate) method as shown here: Noi = property Value/Cap Rate T
The value of Cre may be thought about by applying the Cap Rate to the Noi as shown here. Sample Calculation: 0,000 Noi= ,000,000 Value/10% Cap
Once the value is established, the lender will determine how much of the value of the property the lender is willing to fund straight through mortgage financing. If the lender feels the property type and location carries miniature risk the lender may finance 90% or more of the property.
Sample Calculation: $ 1,000,000 Value x 75% Ltv $ 750,000 Loan Some property types and locations are seen as riskier to a lender and the Ltv may be as low as 60%. Debt assistance Coverage Ratio (Dcr) In addition to being sure that the lender has a protection upholstery over and above the estimate of financing they put on the property, the lender wants to be sure that the borrower has the quality to make the mortgage or every year Debt assistance (Ads) payments in the event that the financial projections are not being et. Noi = Dcr/Ads Sample Calculation: 0.000 Noi = 1.25 Dcr $ 80,000 Ads
In all but the rarest instances the Dcr is greater than 1. This means that the lender will make positive that the Noi is greater by some ration than the Ads. In other words, the lender wants to be sure that there is a cushion. The lender wants to make sure in this example that there is 25% more income produced by the property than is required to make the payments. This way, if the property increases in vacancy for some surmise and/or the Noi drops, the property owner can still make the payments without having to use his/her own resources. The property's cash flow called Noi makes the payments.
Putting it together in an example Assume that the lender agrees that the Noi on a property is 0,000 and that the property has a ,000,000 value based on a Cap Rate of 10%. The lender quotes a 75% Ltv. The lender would be willing to make a 0,000, assuming the property generates enough Noi to make the Ads the loan, which at the current interest rate and term is calculated as ,000. If the lender is quoting a 1.25 Dcr the lender will allow ,000 of the property's 0,000 cash flow to qualify the property for the every year debt assistance (Ads).
In other words, if the Ads is more than ,000, the property will not qualify for the loan. In this situation the lender is satisfied with both the Ltv and the Dcr and will make the loan. However, using the same information, what if the lender stated that the Dcr required is 1.33 and the estimate allowed for Ads would only be ,000? At the current interest rate and terms offered by the lender, ,000 of Ads can only make the payments on a 0,000 loan. As a result of underwriting the loan in the most conservative way, the lender will offer the borrower the 0,000 loan which results in an Ltv of 70%.
Loan underwriting also works the other way. Perhaps the lender is willing to make the 0,000 loan based on the 75% Ltv. The lender quotes a Dcr of 1.2, which would allow the borrower to make every year payments of ,330.00. At the current interest rate and term offered by the lender, ,333 of Ads would make the payments on a loan that is larger than 0,000, but the lender cannot exceed the 75% Ltv so the lender will offer the most conservative loan which will be the 0,000 loan. When a borrower makes an application for a loan to finance Cre, the lender will underwrite the property based on its value and its income stream using both Ltv and Dcr to make the loan thought about to have the least risk.
Apartment Financing - through the Lender's Eyes