The term “Pro Forma” is short for Pro Forma Operating Statement. A pro forma is an annual operating budget for an income property and is probably the most important single document in an income property loan package. An experienced processor will always assemble the package with the pro form as one of the very first items prepared.
Because you have been provided a form entitled ‘Pro Forma Operating Statement” the actual preparation of a pro forma is merely a matter of filling in the blanks. The numbers you choose to insert, however, must be supportable and well documented. While preparing your statement make sure that the operating expenses ratio you are using is not less than 30-35%. Remember the loan size, rather than the interest rate or points, is usually the sticking point in income property negotiations.
Multi-Family Properties
First let us discuss Gross Scheduled Rents. You should usually use the current actual rent roll. Make sure to include on your rent roll the potential rent of any vacant units. Scheduled increases in rent may be allowed, but usually they would have to be in place before the loan funds for the new higher numbers to be factored in.
The required Vacancy Allowance will vary based on property type and location. A good rule of thumb is to use the lesser of actual vacancy or market vacancy (with a minimum of 5%.) The estimated market vacancy can be found at sites like www.irr.com or from a local Real Estate agent.
Borrowers will often protest with claims of actual vacancy rates of 2% to 3%. In these cases remind your borrower that a Vacancy Allowance is really a shortened version of Vacancy and Collection Loss Allowance. Anyone in business eventually gets a few bounced checks and/or deadbeats.
Inserting the actual operating expenses is greatly simplified if the borrower already has a well done appraisal he can provide. In this case, simply insert the expenses as listed in the appraisal, and footnote them as follows: Based on the MAI appraiser’s estimate.
However, you usually should not order an appraisal. In many circumstances the Lender will not accept an appraisal that they did not order. It is also wise to hold off on such a large expense until the lender has reviewed the package and the borrower has accepted in writing the lender’s proposal. Therefore you must be prepared to estimate the expenses yourself and to document them well.
Ideally you will want to review the past 2 years and the year to date operating expenses for the property you are looking to finance. It is always best when a property has an increasing pattern of cash flow, and reviewing more than a few months of data can help do this for you. Do not forget to ask questions about large expenses you may notice on the statements. The most common deviation is the result of non-recurring expenses (such as from a major remodeling), and they can often be extracted from your Pro-forma to lower the estimated expenses on the property.
Thursday, September 6, 2007
Wednesday, August 29, 2007
Common Lease types
I am not a real estate agent, nor a property management expert. Therefore this brief, simplistic summary of commercial real estate leases is taken from my experience reading the leases as we underwrite deals.
With that said, commercial and industrial properties can be leased in a variety of lease agreements. The tenant might be responsible for the real estate taxes, the insurance premiums, and the repairs; or the lessor (owner) may be responsible for all of them. Another possibility is for the owner to be responsible for taxes and insurance, and for the tenant to be responsible for the rest of the operating expenses.
With that said, commercial and industrial properties can be leased in a variety of lease agreements. The tenant might be responsible for the real estate taxes, the insurance premiums, and the repairs; or the lessor (owner) may be responsible for all of them. Another possibility is for the owner to be responsible for taxes and insurance, and for the tenant to be responsible for the rest of the operating expenses.
In fact, there could be an endless variety of ways the lease can be structured. However, the most common lease types are as follows:
- A full service lease is a lease in which the lessor (owner) is responsible for all of the operating expenses, including but not limited to taxes, insurance, repairs, and utilities.
- A net lease (N) is a lease in which some of the operating expenses are paid by the tenant. A net-net (NN) lease is a lease in which the lessee (tenant) pays the two major expense items: taxes and insurance.
- A triple net lease (NNN) is a lease in which the tenant is responsible for “all” of the operating expenses. This includes, but is not limited to, the three most significant expense items: taxes, insurance, and utilities. A true triple net lease is one in which the lessee (tenant) pays all of the operating expenses and the lessor (owner) simply receives his one check every month. Unfortunately the term is often misapplied to leases in which the lessee pays for most, but not all of the operating expenses. You are cautioned to read the lease carefully to determine which expenses each party is responsible for.
Expenses often paid by the lessor (owner) in so called “triple net” leases are management, common area maintenance (CAM) and common area utilities.
Many Multi-tenant buildings are leased on a “triple net” basis where the real estate taxes, the insurance, the common area utilities, and the common area maintenance expenses are prorated among the tenants on a pro rata basis. The basis most commonly used is the net rentable square footage of each tenant’s space as a percentage of the total net rentable square footage. By net rentable square footage we mean the space actually available for rent as opposed to the gross square footage which includes hallways, stairwells, elevator shafts, and lobbies.
With this simple overview you should be better able to analyze deals and put together useful operating statements.
Friday, August 24, 2007
The Operating Expense Ratio
In my experience it is the size of a loan that the borrower can obtain that is usually more of a sticking point than the rate or the loan fee. Now that you all know that loan sizes are generally limited by the debt service coverage ratio (i.e., cash flow) rather than the LTV, the operating expense figure that the lender uses in his calculations is critical.
Whereas operating expense ratios are helpful in evaluating Multi-family properties, they are not as useful for commercial or industrial properties. This is because those spaces can be rented on a triple net basis, a net basis, or a full service basis.
Let’s suppose you have a commercial property with gross leases and the following Operating Statement: [Click here to view a PDF of the statement]
The operating expense ratio is defined as follows:
Operating Expense Ratio = Total Operating Expenses
______________________________EGI
or in our example,
Operating Expense Ratio = $159,311 = 44.7%
_______________________$356,670
Appraisers and professional property managers often keep track of the operating expenses of the buildings they appraise or manage, and publish their results. For example, the National Association of Realtors publishes the results of their surveys annually in several hardbound books including Income and Expenses Analysis – Apartments and Income and Expense Analysis – Office Buildings.
Lenders have access to these types of publications and therefore are reluctant to accept at face value operating expenses supplied by the borrower when their operating expense ratios are less than those experienced by similar buildings in the area.
It might be possible to operate an apartment building or commercial building with gross leases IN THE SHORT RUN at an operating expense ratio of less than 30%. However, in the LONG RUN the end result will be a seriously deteriorated building. It might be possible to get an operating expense ratio as low as 28% accepted on a very new building if it had fewer than 10 or so units, and if it had no pool and very little landscaping, and if you had 2 to 3 years of authentic source documents to back up your claim. But in general, it is difficult to get operating expense ratios on apartments of less than 30% accepted.
The following are factors that will influence the lender to use a higher operating expense ratio:
1. Lack of individual metering or utilities
2. Swimming pool
3. Elevator
4. Extensive landscaping
5. Low income area and/or tenants
6. Presence of families with children
In general, larger projects will require a larger required operating ratio. Large projects usually entail extensive recreational facilities and pools, and often require a full time on-site management team.
So after you are done putting together the operating statement with the information from the borrower double check the operating expense ratio to see if it will meet what most lenders are looking for.
Whereas operating expense ratios are helpful in evaluating Multi-family properties, they are not as useful for commercial or industrial properties. This is because those spaces can be rented on a triple net basis, a net basis, or a full service basis.
Let’s suppose you have a commercial property with gross leases and the following Operating Statement: [Click here to view a PDF of the statement]
The operating expense ratio is defined as follows:
Operating Expense Ratio = Total Operating Expenses
______________________________EGI
or in our example,
Operating Expense Ratio = $159,311 = 44.7%
_______________________$356,670
Appraisers and professional property managers often keep track of the operating expenses of the buildings they appraise or manage, and publish their results. For example, the National Association of Realtors publishes the results of their surveys annually in several hardbound books including Income and Expenses Analysis – Apartments and Income and Expense Analysis – Office Buildings.
Lenders have access to these types of publications and therefore are reluctant to accept at face value operating expenses supplied by the borrower when their operating expense ratios are less than those experienced by similar buildings in the area.
It might be possible to operate an apartment building or commercial building with gross leases IN THE SHORT RUN at an operating expense ratio of less than 30%. However, in the LONG RUN the end result will be a seriously deteriorated building. It might be possible to get an operating expense ratio as low as 28% accepted on a very new building if it had fewer than 10 or so units, and if it had no pool and very little landscaping, and if you had 2 to 3 years of authentic source documents to back up your claim. But in general, it is difficult to get operating expense ratios on apartments of less than 30% accepted.
The following are factors that will influence the lender to use a higher operating expense ratio:
1. Lack of individual metering or utilities
2. Swimming pool
3. Elevator
4. Extensive landscaping
5. Low income area and/or tenants
6. Presence of families with children
In general, larger projects will require a larger required operating ratio. Large projects usually entail extensive recreational facilities and pools, and often require a full time on-site management team.
So after you are done putting together the operating statement with the information from the borrower double check the operating expense ratio to see if it will meet what most lenders are looking for.
Tuesday, August 21, 2007
Credit Market Crisis Counsel
This commentary from CNN Money was too good not to post. It is a little long but well worth the read:
"Stupid" investors, rejoice! 
Ben Stein Economist, writer, lawyer, and actor
Ben Stein Economist, writer, lawyer, and actor
No one is too stupid to make money in the stock market. But there are many who are too smart to make money.
To make money, at least in the postwar world, all you have to do is buy the broad indexes domestically--both in the emerging world and in the developed world--and, to throw in a little certainty about your old age, maybe buy some annuities.
To lose money, pretend you're really, really clever, and that by reading financial journalism and watching CNBC, you can outguess the market day by day. Along with that, you must have absolutely no sense of proportion about money and the world at large.
For example, right now we are stewing over what everyone calls "the subprime mess" and going crazy, mourning all day and into the night--falling over ourselves to get all of the misery right, to paraphrase Evita. I'm writing this on Aug. 13, 2007, and in the past four or five weeks, the markets of the U.S. have lost some 7% of their value, or about $1 trillion.
But read on: The subprime mortgage world is about 15% of all mortgages, or $1.5 trillion worth, very roughly. About 10%--approximately $150 billion--is in arrears. Of that, something like half is in default and will likely be seized in foreclosure and sold. That comes to about $75 billion. Roughly half to two-thirds of that will be realized on liquidation, leaving a loss of maybe $37 billion. Not chump change by any means--but one-thirtieth, more or less, of what has been knocked off the stock market.
The "smart" investor nevertheless reads the papers, bails out, heads for the hills, and stocks up on canned foods. He gets a really big charge out of reading in the press that there are also problems in the mergers and acquisitions market and that some deals will not go through because there are problems raising the funds for the deal. He does not see that the total value of the U.S. major stock markets (the Wilshire 5000) is roughly $18 trillion. The value of the deals that have failed in the private equity world is in the tens of billions or less. The loss to investors--what the merger price was compared with the normalized premerger price--is in the billions. It's real money, and I could buy my wife some nice jewelry with it, but it's pennies in the national or global systems.
The "smart" investor also reads that the Fed has injected, say, $100 billion into the banking system in the last week or ten days, and says, "Aha! The whole country is vaporizing. Look how desperate the system is for money!" What he does not see is that the Fed is always either adding or subtracting liquidity and that recent moves are tiny in the context of a nation with a money supply in the range of $12 trillion. No, the "smart" investor is far too busy looking for reasons to run for cover and thinks he can outsmart long-term trends.
The stupid investor knows only a few basic facts: The economy has not had one real depression since 1941, a span of an amazing 66 years. In the roughly 60 rolling-ten-year periods since the end of World War II, the S&P 500's total return has exceeded the return on "risk-free" Treasury long-term bonds in all but four ten-year periods--the ones ending in 1974, 1977, 1978, and 2002. The first three of these were times of seriously flawed monetary policy that allowed stagflation, and the last one was on the heels of the tech crash and the worst peacetime terrorist attack in the history of the Western world.
The inert, lazy, couch potato investor (to use a phrase from my guru, Phil DeMuth, investment manager and friend par excellence) knows that despite wars, inflation, recession, gasoline shortages, housing crashes in various parts of the nation, riots in the streets, and wage-price controls, the S&P 500, with dividends reinvested, has yielded an average ten-year return of 243%, vs. 86% for the highest-grade bonds. That sounds pretty good to him.
The "smart" investor, in a bunker in the Montana wilderness, keeps his money in gold bullion. After all, he's heard that home prices are falling slightly nationwide and a lot in some areas (he ignores areas of rising prices like San Francisco and New York City). He says that this will discourage the consumer and lead to a severe, bottomless recession. He even has bald people on TV telling him he's right to worry.
The stupid investor, the guy who just lies on his couch, knows that the consumer is always about to stop buying and never quite does. Maybe someone in his bowling club has told him there has only been one year since 1959 when consumer spending fell--and that was barely, in 1980. Somehow, if the consumer could keep spending after the bursting of the tech bubble wiped out $7 trillion or so of wealth, maybe the consumer can keep spending even if the subprime "mess" wipes out roughly half of 1% of that tech-bubble loss and the stock market has a fit. And maybe he knows that, even if there is a recession, recessions rarely last more than two quarters, and the economy and the stock market revive mightily after that--and that buying stocks in a recession is a good idea, not a bad idea.
Now, the alert reader may at this point be saying, "Hey, that `stupid' guy who's really smart is a long-term investor. That's why he's doing so well." Correctamundo, alert reader. There used to be a saying: "Bulls make money and bears make money, but hogs get slaughtered." I am not sure that was ever true, but it sure ain't now. The real story is that long-term investors who have some sense of proportion make money. Short-term investors who live and die by the sweep-second hand of the $300,000 watch get rich fast and poor fast and sometimes are slaughtered faster. I have no advice for them except that the next train may be bringing in someone a little younger who's a little faster on the draw and a lot hungrier, so they'd better enjoy their Gulfstream while they have it.
For the rest of us, the stock market is cheap on a price-earnings basis, profits are fabulous, Mrs. Clinton and Mr. Giuliani are far from being socialists and in the long run, both here and abroad, stocks are a lovely place to be. I have no idea what the S&P will be ten days from now, but I am confident it will be a lot higher ten years from now, and for most Americans, that's what we need to think about. The subprime and private equity and hedge fund dogs may bark, but the stock market caravan moves on.
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Thursday, August 16, 2007
How to calculate the maximum loan amount a property can support
The Google robots had us down for a day or two but we are back up and running. I guess we had so many people check out the updates on Monday that it triggered their SPAM alert. Alas...they discovered I was a Human Being (their wording) and unlocked the Blog.
Anyways, I am often approached by brokers wanting to know how high their investors can push their loan amounts. The LTV of the particular program does influence the answer to this question, but not nearly as much as the NOI of the property.
SO WHAT IS MY MAXIMUM LOAN AMOUNT?
The maximum LTV most income property lenders will lend to is 80%. However, the DSCR may reduce the LTV which the property qualifies for. This discussion will describe how income property lenders arrive at the maximum amount they will lend. This is probably the most important topic in income property finance.
The key to determining the maximum loan a borrower can get is DSCR. You will remember that DSCR is defined as NOI divided by total debt service.
Also remember that total debt service includes the P&I payments on all the mortgages that will remain on the property after your new loan is arranged.
Before proceeding let us review a little basic algebra. You will recall that if we have an equality; i.e. an algebraic expression separated by an equal sign, we can multiply or divide one side of the equation by anything we want, as long as we perform the identical operation to the other side of the equal sign.
For example, let us start with the following equation:
___ 6 = 2
___ 3
If we multiply both sides by 3, the equality holds:
___ 6 = 2 x 3
Armed with this brief refresher, let’s go back and use the debt service coverage ratio (DSCR) to determine the maximum loan our borrower can qualify for. Let’s suppose that we need a 1.25 DSCR for a very attractive apartment loan. If we use the same operating statement that we used in our discussion on the DSCR in my earlier post, we will see that we have a NOI of $55,000 per year available.
Substituting the numbers we have into the DSCR equation we find:
DSCR = NOI → 1.25 = $55,000 → Debt Service = $55,000 = $44,000
___Debt service___Debt Service_______________1.25
Now you can simply work backwards to determine the maximum loan amount the property will qualify for. Let’s assume the apartment loan being quoted was at 7% with a 30 year amortization. Now using your financial calculator use 360 for N, 7% for the % rate, -$3,667 ($44,000 divided by 12) for PMT, and then solve for PV. This should give you a maximum loan amount for this property of $551,127.
Knowing how the ratios work, you should be able to see that there are two ways that the loan amount can be increased. The first is to find the programs with the lowest DSCR requirements. This can be tricky because some programs that offer a low 1.15 DSCR requirement may come up with the same maximum loan amount if they have higher default expenses that need to be utilized.
The second thing that can be done to increase loan amounts is to find ways to increase the properties NOI. This may be done through more straight forward changes such as increasing rents or decreasing the vacancy rate in the property. More complex ways to increase the NOI would involve lowering expenses. The utility expenses are always a good place to start, but property tax and insurance expenses can also be a source of saved revenue if they can be lowered.
Please let me know if you have questions about ways to maximize the loan amounts of the properties you work with.
Anyways, I am often approached by brokers wanting to know how high their investors can push their loan amounts. The LTV of the particular program does influence the answer to this question, but not nearly as much as the NOI of the property.
SO WHAT IS MY MAXIMUM LOAN AMOUNT?
The maximum LTV most income property lenders will lend to is 80%. However, the DSCR may reduce the LTV which the property qualifies for. This discussion will describe how income property lenders arrive at the maximum amount they will lend. This is probably the most important topic in income property finance.
The key to determining the maximum loan a borrower can get is DSCR. You will remember that DSCR is defined as NOI divided by total debt service.
Also remember that total debt service includes the P&I payments on all the mortgages that will remain on the property after your new loan is arranged.
Before proceeding let us review a little basic algebra. You will recall that if we have an equality; i.e. an algebraic expression separated by an equal sign, we can multiply or divide one side of the equation by anything we want, as long as we perform the identical operation to the other side of the equal sign.
For example, let us start with the following equation:
___ 6 = 2
___ 3
If we multiply both sides by 3, the equality holds:
___ 6 = 2 x 3
Armed with this brief refresher, let’s go back and use the debt service coverage ratio (DSCR) to determine the maximum loan our borrower can qualify for. Let’s suppose that we need a 1.25 DSCR for a very attractive apartment loan. If we use the same operating statement that we used in our discussion on the DSCR in my earlier post, we will see that we have a NOI of $55,000 per year available.
Substituting the numbers we have into the DSCR equation we find:
DSCR = NOI → 1.25 = $55,000 → Debt Service = $55,000 = $44,000
___Debt service___Debt Service_______________1.25
Now you can simply work backwards to determine the maximum loan amount the property will qualify for. Let’s assume the apartment loan being quoted was at 7% with a 30 year amortization. Now using your financial calculator use 360 for N, 7% for the % rate, -$3,667 ($44,000 divided by 12) for PMT, and then solve for PV. This should give you a maximum loan amount for this property of $551,127.
Knowing how the ratios work, you should be able to see that there are two ways that the loan amount can be increased. The first is to find the programs with the lowest DSCR requirements. This can be tricky because some programs that offer a low 1.15 DSCR requirement may come up with the same maximum loan amount if they have higher default expenses that need to be utilized.
The second thing that can be done to increase loan amounts is to find ways to increase the properties NOI. This may be done through more straight forward changes such as increasing rents or decreasing the vacancy rate in the property. More complex ways to increase the NOI would involve lowering expenses. The utility expenses are always a good place to start, but property tax and insurance expenses can also be a source of saved revenue if they can be lowered.
Please let me know if you have questions about ways to maximize the loan amounts of the properties you work with.
Friday, August 10, 2007
Commercial Crunch
Unless you have been on vacation in the Bahamas for the past 6 months, you should be aware of the serious credit market concerns in the residential mortgage market.
In fact, check out these new "Guidelines" I received from a Residential Lender today:
So what is being done about it?
The past couple of months have had investors taking the classic "flight-to-quality" move into bonds. This has caused Bond yields to drop considerably over the past few months, though continued market volatility is expected for the coming weeks.
Though the Federal Funds rate is typically how the Fed influences market stability they took another course of action today. They first announced that $19B would be pumped into the banking system in an attempt to alleviate the growing concerns about liquidity, and then increased it to $35B and finally $38B. This mirrors the actions of the European Central Bank pumping $213B of liquidity into their banking system over the past two days.
From a financial point of view the $38 Billion infused by the Fed is a small ripple in the wake of the US economy. However, we live with an emotional market as much as we do a financial one and so the infusion is bound to settle some concerns about the markets liquidity and stability.
So how can you be successful in such a turbulent time?
Commercial Mortgage Backed Securities (CMBS) deals have traditionally had rates which were much lower than portfolio style programs. The credit crunch we are in the middle of has changed the playing field, and as a result that difference in rates is not always the case anymore.
For example, we recently received a quote back from a top CMBS source and for that deal it was 15 bps higher than what we could offer on one of our own portfolio style programs. We are able to close the deal either way, but it sure was great to be able to offer a program with a rate lower than what the other conduits were offering. Throw in the lower application fees, less restrictive prepayment penalties, and greater program flexibility and it was a great deal for the borrower.
What this means for you is that it is now easier to win over some of those $2-$5M deals with faster, less expensive, portfolio style programs. The key is to find programs that you know offer a competitive advantage to what the market is offering, and then go out and find the properties which fit those programs.
In fact, check out these new "Guidelines" I received from a Residential Lender today:
- All borrowers must have one Blue eye and one Brown eye
- LTV > 65% on SIVA asset programs require minimum credit scores of 849
- For all LTV's > 65%, 360 months of reserves are now required
- Borrowers must have no previous bankruptcies in their family history going back three generations
- A minimum of 25 years self-employment history is now required for all NIV Programs (at same location)
- Minimum credit scores for Subprime loans is raised to 720
- All non-arm's length transaction borrowers (mortgage, real estate professionals, family members) will be required to provide full-documentation, subject to criminal background checks, wire tapping, strip searches, and a minimum of 12 hours of interrogation by the Department of Homeland Security
Now that we have all had a good laugh, let's hope it really never comes down to this!
Anyways, during the first quarter of the year it looked like the credit market concerns would be limited to the Residential market, but that is no longer the case. With the relative strength of commercial paper being called into question, the PAR spreads we've known over the past several years have all been increased dramatically and higher LTV deals are also being cracked down on.
So why the tightening of the guidelines? In a very simplistic explanation, lenders are taking these actions to ensure that they can find a "buyer" when it comes time to securitize their notes. These deals are being affected because of the growing concern about the liquidity in the market to support such large transactions (securitizations can top $1B with ease).So what is being done about it?
The past couple of months have had investors taking the classic "flight-to-quality" move into bonds. This has caused Bond yields to drop considerably over the past few months, though continued market volatility is expected for the coming weeks.
Though the Federal Funds rate is typically how the Fed influences market stability they took another course of action today. They first announced that $19B would be pumped into the banking system in an attempt to alleviate the growing concerns about liquidity, and then increased it to $35B and finally $38B. This mirrors the actions of the European Central Bank pumping $213B of liquidity into their banking system over the past two days.
From a financial point of view the $38 Billion infused by the Fed is a small ripple in the wake of the US economy. However, we live with an emotional market as much as we do a financial one and so the infusion is bound to settle some concerns about the markets liquidity and stability.
So how can you be successful in such a turbulent time?
Commercial Mortgage Backed Securities (CMBS) deals have traditionally had rates which were much lower than portfolio style programs. The credit crunch we are in the middle of has changed the playing field, and as a result that difference in rates is not always the case anymore.
For example, we recently received a quote back from a top CMBS source and for that deal it was 15 bps higher than what we could offer on one of our own portfolio style programs. We are able to close the deal either way, but it sure was great to be able to offer a program with a rate lower than what the other conduits were offering. Throw in the lower application fees, less restrictive prepayment penalties, and greater program flexibility and it was a great deal for the borrower.
What this means for you is that it is now easier to win over some of those $2-$5M deals with faster, less expensive, portfolio style programs. The key is to find programs that you know offer a competitive advantage to what the market is offering, and then go out and find the properties which fit those programs.
Wednesday, August 8, 2007
Key Commercial Ratios Part II
Before I get to a post on the current secondary market credit crunch and how it is affecting Commercial financing, I thought I would quickly finish what I started yesterday.
Though not nearly as important as the Debt Service Coverage Ratio, Loan to Value ratios do affect the types of programs available to borrowers. Here is a quick summary on commercial Loan to Value ratios.
Loan to Value Ratio
The Loan-To-Value Ratio (LTV) is defined as follows:
Loan-To-Value = Total loan balances
_____________Fair market value
Generally the fair market Value of a property is determined by an appraisal. There is one important exception, however. On a purchase transaction, if the appraisal comes in lower than the purchase price, then the lender will use the LOWER of the purchase price or appraisal.
Commercial Lenders are often asked by real estate agents and buyers to base their loan on the appraised value rather than the purchase price. Their claim is that they have negotiated a super deal and that the property is worth much more than what they are paying for it. Perhaps so (but generally untrue), but lenders always base their maximum loan on the lower of purchase price or appraisal.
The lender’s argument (it's their money, so there is really very little argument) is that an appraisal is really no more than an estimate of fair market value, no matter how competent or conscientious the appraiser may be. The only true indicator of value is the marketplace in which a willing buyer and a willing seller, each in full knowledge of the salient facts, and neither under undue pressure, agree upon terms. If the property sells for “X”, then it is probably only worth “X”.
Loan-To-Value Ratios for conforming commercial properties seldom exceed 80-90% because the lender always wants some extra protection against default. There are smaller balance programs which allow for higher LTV's than this, but they are usually based on the strength of the borrower and not the property.
A word of caution about these high LTV programs: their rates are usually 2-5% higher than what a conforming program may be able to offer. This may work in the short run, but for long term investors leveraging a property to this extreme has a devastating affect on cash flow.
Though not nearly as important as the Debt Service Coverage Ratio, Loan to Value ratios do affect the types of programs available to borrowers. Here is a quick summary on commercial Loan to Value ratios.
Loan to Value Ratio
The Loan-To-Value Ratio (LTV) is defined as follows:
Loan-To-Value = Total loan balances
_____________Fair market value
Generally the fair market Value of a property is determined by an appraisal. There is one important exception, however. On a purchase transaction, if the appraisal comes in lower than the purchase price, then the lender will use the LOWER of the purchase price or appraisal.
Commercial Lenders are often asked by real estate agents and buyers to base their loan on the appraised value rather than the purchase price. Their claim is that they have negotiated a super deal and that the property is worth much more than what they are paying for it. Perhaps so (but generally untrue), but lenders always base their maximum loan on the lower of purchase price or appraisal.
The lender’s argument (it's their money, so there is really very little argument) is that an appraisal is really no more than an estimate of fair market value, no matter how competent or conscientious the appraiser may be. The only true indicator of value is the marketplace in which a willing buyer and a willing seller, each in full knowledge of the salient facts, and neither under undue pressure, agree upon terms. If the property sells for “X”, then it is probably only worth “X”.
Loan-To-Value Ratios for conforming commercial properties seldom exceed 80-90% because the lender always wants some extra protection against default. There are smaller balance programs which allow for higher LTV's than this, but they are usually based on the strength of the borrower and not the property.
A word of caution about these high LTV programs: their rates are usually 2-5% higher than what a conforming program may be able to offer. This may work in the short run, but for long term investors leveraging a property to this extreme has a devastating affect on cash flow.
Tuesday, August 7, 2007
Two Key Commercial Ratios
Most of Commercial Real Estate Lending can be boiled down to the results of two ratios:
1. Debt Service Coverage Ratio (DSCR) or Debt Coverage Ratio (DCR)
2. Loan-To-Value (LTV) Ratio
The bulk of the energy spent “processing” a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the above ratios. Today I will cover Debt Service Coverage ratios, and I will post an update later on the Loan to Value ratio.
Debt Service Coverage Ratio
The most important ratio to understand when making income property loans is the Debt Service Coverage Ratio. The DSCR is a sophisticated ratio used on almost all income producing properties. It is defined as:
Debt Service Coverage Ratio = Net Operating Income
_______________________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 an income producing property after paying all of the operating expenses. A simplified example may look like this:
Gross scheduled Rents______________$100,000
Less 5% vacancy & collection loss_______$ 5.000
Equals Effective Gross Income_________$ 95,000
Less Operating Expenses
_________Real Estate Taxes
_________Insurance
_________Repairs & Maintenance
_________Utilities
_________Management
_________Reserves for Replacement
_________Total operating expenses____$ 40,000
Equals Net Operating Income (NOI)_____$ 55,000
Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate of the property. Typically it is the lower of the actual vacancy of the property or the typical vacancy in the subject properties area for similar properties.
In addition, lenders always insist on using some sort of management expense regardless of whether or not the owner self manages the property. A typical factor is around 4% of the effective gross income, but that can vary based on the market and property type. Their logic is that they would have to pay for management if they took back the property.
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.
To calculate the debt service coverage ratio, simply divide the NOI by the mortgage payment(s). Let's assume that there is only one mortgage on the property and it has the following terms:
___$500,000 Loan Amount - 8% Interest - 30 year amortization
_________Annual Payment (Debt Service) = $44,025
It then follows that:
DSCR = Net Operating Income (NOI) of $55,000 = 1.25
__________Total Debt Service of $44,025
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. Conversely the borrower wants as large a loan as possible.
If the loan amount is increased, the debt service requirement will increase as well. Therefore, if the net operating income stays the same but the loan size increases, the DSCR will be lower.
A DSCR of 1.0 is breakeven cash flow. That is because the 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 .95 would mean that there is only enough 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. All lenders frown on negative cash flow, though there are some programs (in select markets) where it is still possible to do the deal with a DSCR of less than 1.0.
1. Debt Service Coverage Ratio (DSCR) or Debt Coverage Ratio (DCR)
2. Loan-To-Value (LTV) Ratio
The bulk of the energy spent “processing” a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the above ratios. Today I will cover Debt Service Coverage ratios, and I will post an update later on the Loan to Value ratio.
Debt Service Coverage Ratio
The most important ratio to understand when making income property loans is the Debt Service Coverage Ratio. The DSCR is a sophisticated ratio used on almost all income producing properties. It is defined as:
Debt Service Coverage Ratio = Net Operating Income
_______________________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 an income producing property after paying all of the operating expenses. A simplified example may look like this:
Gross scheduled Rents______________$100,000
Less 5% vacancy & collection loss_______$ 5.000
Equals Effective Gross Income_________$ 95,000
Less Operating Expenses
_________Real Estate Taxes
_________Insurance
_________Repairs & Maintenance
_________Utilities
_________Management
_________Reserves for Replacement
_________Total operating expenses____$ 40,000
Equals Net Operating Income (NOI)_____$ 55,000
Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate of the property. Typically it is the lower of the actual vacancy of the property or the typical vacancy in the subject properties area for similar properties.
In addition, lenders always insist on using some sort of management expense regardless of whether or not the owner self manages the property. A typical factor is around 4% of the effective gross income, but that can vary based on the market and property type. Their logic is that they would have to pay for management if they took back the property.
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.
To calculate the debt service coverage ratio, simply divide the NOI by the mortgage payment(s). Let's assume that there is only one mortgage on the property and it has the following terms:
___$500,000 Loan Amount - 8% Interest - 30 year amortization
_________Annual Payment (Debt Service) = $44,025
It then follows that:
DSCR = Net Operating Income (NOI) of $55,000 = 1.25
__________Total Debt Service of $44,025
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. Conversely the borrower wants as large a loan as possible.
If the loan amount is increased, the debt service requirement will increase as well. Therefore, if the net operating income stays the same but the loan size increases, the DSCR will be lower.
A DSCR of 1.0 is breakeven cash flow. That is because the 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 .95 would mean that there is only enough 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. All lenders frown on negative cash flow, though there are some programs (in select markets) where it is still possible to do the deal with a DSCR of less than 1.0.
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