Commercial loan underwriting depends on a great number of factors including type of property, requirement, usage, etc. However, certain basic ratios are applicable to every commercial loan.
Debt Service Coverage Ratio
This ratio determines whether a property would be able to cover the mortgage and all other expenses tied to the property. Lenders generally calculate this ratio to ensure that cash flow would be positive and that income is more than expenses so that buyer could manage unexpected expenses.
The breakeven for Debt Service Coverage Ratio is 1.0 DSCR, (when income equals expenses). However, most loan programs require a 1.2 – 1.35 DSCR or 20% - 30% more income than anticipated expenses on the property.
The DSCR is however, much more (2.0 + DSCR) for owner occupied businesses where there is no rental income, because lenders, in such case, estimate the strength of the business as opposed to the property itself.
However, DSCR can vary depending on loan size, interest rate, and amortization.
DSCR in details
Debt Service Coverage Ratio or DSCR as they are more widely recognized, are the most important ratio that buyers must understand when making income property loans. All lenders use them in calculating their amount they are willing to lend.
DSCR = Net Operating Income (NOI) / Total Debt Service
Before understanding DSCR, you need to understand the net operating income and total debt service.
Net operating income (NOI)
This is the income from a rental property left over after paying all of the operating expenses:
For example:
| Gross Scheduled Rents |
$100,000 |
| Less 5% Vacancy & Collection Loss |
$5,000 |
| Effective Gross Income |
$95,000 |
Less Operating Expenses
Real Estate Taxes
Insurance
Repairs & Maintenance
Utilities
Management
Reserves for Replacement
| Total Operating Expenses: |
$30,000 |
| Net Operating Income (NOI) |
$65,000 |
WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.
Lenders always insist on some sort of vacancy factor irrespective 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.
Total Debt Service
This includes the principal and interest payments of all loans on the property (not only the initial mortgage).
TOTAL DEBT SERVICES DO NOT INCLUDE TAXES AND INSURANCE.
Total Debt Service coverage ratio calculation
Net operating income (NOI) / mortgage payment(s)
Lets take the following example:
Assuming that there is only one mortgage on the property:
| First mortgage |
$500,000 |
Annual Payment (Debt Service)
(11% Interest, 30 years amortized) |
$57,139 |
| DSCR= Net Operating Income (NOI) |
= $65,000 |
| Total Debt to Service |
= $57,139 |
DSCR = 1.14. This means that there is 14% more cash left after paying for the debt
Note: We have shown a management expense and reserve expenses in the above example. Even if you do not pay these expenses, lenders will allocate industry standard percentages against the income for loan purposes.
Considering the above example, it is obvious that higher the DSCR, more the net operating income, and more preferable for lenders.
Life insurance companies are usually very conservative over DSCR and generally require a 1.25 or 1.35 DSCR, meaning that their loan-to-value ratios are low.
Banks and mortgage banks generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.
Loan-to-Value (LTV)
LTV is used to determine what percentage of the property is being financed. Most commercial programs offer a maximum of 60% - 75% depending on property type. This is quite contrary to residential loan programs where 100% (or sometimes 125%) financing is available.
However, some SBA programs can offer up to 90% financing for qualifying properties (usually owner occupied businesses), but it needs to be kept in mind that many properties will be more limited in loan size by DSCR more so than by LTV limits.
Net Operating Income (NOI)
NOI determines the profitability of a property. Net operating income is derived by subtracting expenses from the income. The income is usually decreased by a vacancy factor that the lender feels is conservative. However, depreciation and mortgage payments are not included as expenses in this calculation, but several theoretical expenses may apply in the calculation of NOI (tenant improvements, leasing commissions, etc.).
NOI can also be an important determinant of cash available for debt service by dividing NOI by the minimum DSCR. Divide by 12 for a maximum monthly payment. |
