Commercial Underwriting

Financial Analysis

A key component in making an underwriting evaluation is the debt coverage ratio (DCR). The DCR is defined as the monthly debt compared to the net monthly income of the investment property in question. Using a DCR of 1:1.10 a lender is saying that they are looking for a $1.10 in net income for each $1.00 mortgage payment. Typically they will determine the DCR ratio based on monthly figures, the monthly mortgage payment compared to the monthly net income. The higher the DCR ratio is the more conservative the lender. Most lenders will never go below a 1:1 ratio (a dollar of debt payment per dollar of income generated). Anything less then a 1:1 ratio will result in a negative cash flow situation raising the risk of the loan for the lender. DCR’s are set by property type and what a lender perceives the risk to be. Today, apartment properties are considered to be the least risky category of investment lending. As such, lenders are more inclined to use smaller DCR’s when evaluating a loan request. Make sure that you are familiar with a lender’s DCR policy prior to spending money on an application. Ask them to give you a preliminary review of the investment property that you want to purchase. Information is free, mistakes are not.

Analyzing Debt Service Coverage Ratio (DSCR)

The most important ratio to understand when making income property loans is the debt service coverage ratio. It equals Net Operating Income (NOI) divided by 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 Rent =$200,000 Less 5% Vacancy & Collection Loss =$5,000 Effective Gross Income =$195,000 Less Operating Expenses Real Estate Taxes Insurance Repairs & Maintenance Utilities Management Reserves for Replacement Total Operating Expenses =$75,000 Net Operating Income (NOI) =$120,000

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 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(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:

$500,000 First Mortgage 7.5% Interest, 25 years amortized
Annual Payment (Debt Service) = $44,339

Then:

DSCR = Net Operating Income (NOI) = $60,000 Total Debt Service $44,339 DSCR = 1.35

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 break even 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.

Loan to Value

The loan-to-value (LTV) ratio is probably the most important of the 3 underwriting ratios. The loan-to-value ratio is defined as:LTV Ratio = Total Loan Balances (1st mtg+2nd mtg +3rd mtg) / Fair Market Value of the Property

Unlike residential lending, commercial investment properties are viewed more conservatively. Most lenders will require a minimum of 25% (sometimes 20%) of the purchase price to be paid by the buyer. The remaining 75% can be in the form of a mortgage provided by either a bank or mortgage company. Some commercial mortgage lenders will require more than 25% contribution towards the purchase from the buyer. What a bank/lender will do is subject to their appetite and the quality of the buyer and the property. Loan to value is the percentage calculation of the loan amount divided by purchase price. If you know what a lender’s LTV requirements are, you can also calculate the loan amount by multiplying the purchase price by the LTV percentage. Keep in mind that the purchase price must also be supported by an appraisal. In the event that the appraisal shows a value less then the purchase price, the lender will use the lower of the two numbers to determine the loan that will be made.

Credit Worthiness

For businesses less than three years old, personal credit of principals will be evaluated. This may hold true for longer periods of time for tightly held companies. For corporations, business performance and credit ratings will be evaluated with a proven track record.

Property Analysis

Fair Market Value and Fair Market Rent will be analyzed. Special use property may require additional underwriting. Age, appearance, local market, location, and accessibility are some other factors considered.

Commercial Loans Debt Ratios

When analyzing the personal budget of a borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:

  1. Top Debt Ratio
  2. Bottom Debt Ratio

The “top” debt ratio is defined as: Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income

By “monthly housing expense” we mean either the borrower’s monthly rent payments, or if he/she owns a home, the total of the following:

  • 1st mortgage payment on home
  • Real estate taxes (annual cost/12)
  • Fire insurance (annual cost/12)
  • Homeowner’s association dues (if the home is a condo or townhouse)
  • Second mortgage payment (if any)
  • Third mortgage payment (if any)

You will often hear the term “PITI.” It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While PITI is not exactly the same as Monthly Housing Expense because it does not include homeowner’s association dues, the two terms are often used interchangeably.

Lenders have learned over the years that a borrower’s “top” debt ratio should not exceed 25%. In other words, a person’s housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.

The second ratio that lenders use to determine if a borrower can afford his/her obligations is the “bottomdebt ratio.

It is defined as follows: Bottom Debt Ratio = (Total Housing Expense + Debt Payments) / Gross Monthly Income

The only difference between the two ratios is the inclusion in the numerator of “debt payments.” Debt payments include the following:

  • Car payments
  • Charge card payments
  • Payments on installment loans, for example – a payment on a washer & dryer that the borrower purchased
  • Payments on personal loans, for example, a signature loan from the borrower’s bank.

What is not included in “debt payments” is Utilities such as APS, water or telephone and payments on real estate loans. Real estate loans are usually offset first by the net rental income from the property. If the borrower has a net positive cash flow from all his rentals, then the net income is usually added to his “gross monthly income.” If the borrower has a net negative cash flow from all of his rental properties, then the amount of the negative cash flow is usually added to the numerator of the “bottom” debt ratio as if it were a monthly debt obligation, like a car payment. Traditional lending theory maintains that a borrower’s “bottom” debt ratio should not exceed 33 1/3%. In other words, the total of the borrower’s housing expense and debt obligations should not exceed 1/3 of his income. Lenders often will stretch on this ratio to as high as 36%, and some have even been known to stretch as high as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky loan than a loan with a debt ratio of 32%.