Understanding the commercial real estate loan underwriting process can give you a big advantage when seeking debt financing for a commercial property. In this short article we’ll discuss how lenders underwrite commercial real estate loans, how they determine the maximum loan amount for a property, and then we’ll tie it all together with a clear example.
Before a new loan goes through the full underwriting and credit approval process, the lender and the borrower will often have a preliminary discussion. The purpose of the discussion is to get a better understanding of current interest rates, the bank’s current internal loan policy on underwriting ratios, including the loan to value ratio and debt service coverage ratio, as well as any possible lender adjustments to Net Operating Income (NOI).
At this stage the borrower might submit a rent roll and a real estate proforma for the lender to evaluate internally. Typically the lender will discuss the deal internally with the senior lender or credit officer, and if the bank is comfortable with the deal then they’ll issue a term sheet and move forward with the full underwriting process.
Net Operating Income (NOI)
The first step in commercial real estate loan underwriting is determining the appropriate net operating income. The borrower will typically submit a rent roll and a proforma, but the lender will almost always construct their own proforma for loan underwriting purposes, which may result in a different NOI calculation. Possible lender adjustments to NOI include increasing the vacancy and credit loss factor to account for market conditions or tenant rollover risk, or deducting reserves for replacement from NOI.
After determining NOI, lenders have internal loan policy guidelines they use as underwriting criteria for different real estate projects. The two most important loan underwriting criteria used are the Loan to Value Ratio (LTV) and the Debt Service Coverage Ratio (DSCR).
Loan to Value Ratio (LTV)
The loan to value ratio is simply the ratio of the total loan amount borrowed in relation to the value of the property.
For example, suppose the requested loan amount for a commercial real estate property was $1,000,000 and the the appraisal came in with a value of $1,250,000. The LTV ratio would simply be $1,000,000/$1,250,000, or 80%.
Different banks usually have different but similar LTV requirements. This is driven by each bank’s internal strategic growth goals and existing portfolio concentrations. LTV guidelines also vary by property type to reflect variations in risk. For example, land is considered to be much riskier than a fully leased apartment building, and as such the required LTV on land would be lower.
A critical issue with the loan to value ratio is how a lender determines value. Normally a third-party appraisal firm is engaged to provide a full appraisal report on the property. However, it’s worth noting that the lender doesn’t have to fully accept the appraised value and can still make downward adjustments to the appraisal.
Debt Service Coverage (DSCR)
The debt service coverage ratio is the ratio of NOI to annual debt service. The reason why this ratio is important to lenders is because it ensures that the property has the necessary cash flow to cover the loan payments. The DSCR formula can be calculated as follows:
The DSCR gives the lender a margin of safety. For example, by requiring a 1.20x DSCR the lender is building in a cushion in the property’s cash flow over and above the annual debt service. At a 1.20x DSCR the property’s NOI could decline by 17% and the loan payments would still be fully covered.
Like the LTV ratio, the DSCR is set internally by the bank’s loan policy and can vary by property type. Riskier properties like self-storage will typically have higher DSCR requirements than more stable operating properties like apartments.
Maximum Loan Analysis
The purpose of the maximum loan analysis is to determine the maximum supportable loan amount based on the NOI, the DSCR, and the LTV requirements. Once a lender calculates the correct net operating income they will then calculate the above mentioned loan to value and debt service coverage ratios. Next, the lender will then take the lesser of the two loan amounts calculated based on the LTV approach and the DSCR approach.
Let’s take a quick example to clarify how this works. Suppose that you are acquiring a multi-tenant office property with the following 5-year proforma:
Further suppose that after talking to your lender you discover that they require a 1.25x DSCR and an 80% LTV ratio for loans on Class B office space like yours. How big of a loan can you get for your property?
The above table shows the analysis a bank would do for this loan request. First up is the maximum loan amount based on the DSCR approach. As shown above the lender will take the NOI and divide it by the required DSCR. This will result in the portion of NOI that can be used to pay debt service. Next, the lender will use this “Available for Debt Service” figure to back into a loan amount using a loan interest rate and amortization period. In the example above the lender is using a 5% interest rate and a 20 year amortization period. Using a financial calculator this is just solving for the Present Value, given the Rate, Number of Periods, and the Annual Payment. The resulting Present Value is the maximum loan amount the property can support.
Next up is determining the maximum loan amount using the LTV approach. To do this the lender will estimate a value of the property at an appropriate cap rate, which would ultimately be supported by a third party appraisal. In this example the lender is using an 8.5% cap rate, which is divided into the NOI to arrive at an approximate valuation for the property. Finally, the lender will simply apply the required loan to value ratio of 80% to the estimated value to arrive at the maximum loan amount using the LTV approach.
Now the lender has two maximum loan amounts, one based on the DSCR approach ($2,515,270), and another based on the LTV approach ($2,343,482). The last step in calculating the maximum supportable loan amount for the property is to take the lesser of the two amounts. In the example above, this is shown on the last line and is approximately $2,340,000 based on Year 1 NOI.