How Is A Commercial Loan Amount Determined?
Depending on the type of property and transaction, the final loan amount a lender is willing to offer to a borrower varies. Traditional commercial, multifamily, NNN properties, owner-user properties and special purpose properties all have different metrics and underwriting considerations that are important when determining loan amount qualification. The type of lender and transaction is also key -- banks and insurance companies are going to be the most conservative, while private debt funds and other less regulated funding sources will have more leniency and flexibility. Bridge loan providers and hard money private investors might not even have specific qualification standards, and rely more on exit strategy, borrower strength or just a personal proclivity.
However, for the purpose of this article -- we will be doing a brief analysis and explanation of multifamily (5+ units) loan qualification with regulated lenders, which is probably one of the more common requests our company receives. So, how exactly does a bank determine what loan amount they are willing to offer on my multifamily purchase or refinance?
Debt Coverage Ratio (DCR) - The DCR or Debt Service Coverage Ratio (DSCR) is the primary calculation used to determine qualified loan amount. You calculate this by dividing your property NOI (net operating income) by the ADS (annual debt service). The ADS is the total annual mortgage payment for the proposed loan amount you are requesting. So a DCR of 1.25x means that the NOI is 25% higher than the proposed ADS (providing a buffer in the cash flow). The most competitive lenders on the best properties can usually require as low as a 1.15x DSCR, which would generate a higher loan qualification. The higher the DCR, the lower the loan qualification. This can be increased if the lender perceives any type of risk, including property location or borrower strength.
Debt Yield (DY) - The debt yield ratio is calculated by dividing the NOI (net operating income) by the proposed loan amount (multiplied by 100). This method is less commonly used, but still considered and important to know. The higher the debt yield result, the more annual cash flow the property generates to cover the loan payment. Banks will have a minimum DY the property will need to meet.
Comfort Level - Commercial lending is also a subjective determination. While the subject property could have great cash flow and meet all minimum requirements of DCR and DY to achieve their requested loan amount, that loan amount can be limited by the bank’s maximum LTV (loan to value) ratio, and also their comfort level with the deal. If the bank is not comfortable with the property for any reason, they can limit their maximum LTV on that particular transaction. Properties with great cash flow but in more rural areas or rougher neighborhoods typically fall to this rule of thumb.
The primary component of these three loan determinants is the NOI (net operating income). So how does a bank determine the NOI? Keep in mind, the actual NOI and the underwritten NOI is very different. For example, a bank will underwrite for a property management expense even if you will be self-managing and not incurring that expense. It will be a more conservative estimate than your personal pro-forma might conclude. The bank will also rely heavily on the appraisal and the appraiser’s comments and estimates to finalize their offering. The appraiser will have property and submarket specific details on expected expenses, market rents and sales comps to report back to the bank. Here are a few of the key factors that can vary:
Collected Rents - If the actual rents are less than the market rents, select banks will take the market rents into consideration for their NOI calculation so as not to penalize a borrower for finding a bargain purchase. However, the majority of lenders will only use the current rents as pro-forma rents are not promised or guaranteed to be realized.
Vacancy Factor - The rule of thumb for most multifamily underwriting is a 5% vacancy factor to the gross potential income at current rents as a minimum. If the appraiser notes higher vacancy for the property’s submarket, the bank will likely use that percentage. Only a few select banks will use lower than 5% if the report supports it in a high demand market, which would generate a higher loan in theory.
Pro-Forma Expenses - Lower expenses yields a higher NOI, thus a higher loan qualification. Every bank has their own underwriting standards and flexibility, which along with DCR is usually where it gets competitive. Some are able to waive the underwritten management fee if it makes sense, and non-fixed expenses like a repair & maintenance, administrative, or capital expenditure budget can be reduced depending on the condition of the property and comfort level of the underwriter. Some banks will take insurance policy and contract servicing quotes into consideration, if found to be lower than the appraiser’s estimate. All of these little factors can add up in a big way.
Loan Terms - The more attractive loan terms (lower interest rate, higher amortization) the lower the annual debt service (ADS) will be, resulting in a higher loan amount. The borrower will have more cash flow to support the mortgage with a lower payment.
The above is a brief overview of loan underwriting. Every transaction and property is unique and will be qualified based on its own merit. Shameless plug -- it is extremely valuable to have a qualified commercial mortgage broker working on your behalf that understands this process thoroughly, and has the lender relationships to negotiate exceptions on your behalf with the best-fitting bank, in order to maximize your loan qualification. Please contact me if you would like to discuss this article further, or have our team provide you with a complimentary financing analysis for a specific property.
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