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Commercial Lending Ratios

Most of real estate lending can be boiled down to the results of three ratios:

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 3 ratios.

The Loan-To-Value Ratio (LTVR) is defined as follows:
Loan-To-Value= Total loan balances (1st mtg+2nd mtg+3rd mtg) / Fair market value (as determined by appraisal)

Loan-To-Value Ratios seldom exceed 80% because the lender always want some extra protection against default.

The second ratio that lenders use when underwriting a loan is the Debt Ratio. The Debt Ratio compares the amount of bills that the borrower must pay each month to the amount of monthly income he earns. More precisely, the Debt Ratio is defined as:
Debt Ratio = Monthly Debt Obligations / Monthly Income

Obviously someone whose Debt Ratio is 150% is in trouble. A Debt Ratio of 150% would mean that a borrower's obligations are one and a half times his income. Debt Ratios seldom are allowed to exceed 40% in practice.

The final ratio used in lending is the Debt Service Coverage Ratio (DSCR). The Debt Service Coverage Ratio is a sophisticated ratio only used for large loans on income producing properties. It is defined as:
Debt Service Coverage Ratio = Net Operating Income / Debt Service

Net Operating Income is the income from a rental property after deducting for real estate taxes, fire insurance, repairs, and all other operating expenses; and Debt Service is the mortgage payment on the property. Most lenders insist that this ratio exceed 1.0. A debt service coverage ratio of less than 1.0 would mean that the property did not produce enough net rental income for the owner to make the mortgage payments without supplementing the property from his personal budget.

Commercial LTV Ratio

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

First let's look at the numerator. If the borrower is only applying for a first mortgage, and there will be no other loans on the property, then the beginning balance of the new loan requested should be inserted in the numerator.

However, if the borrower is applying for a second mortgage, then the "underwriter" (the person who determines whether or not the loan qualifies) should insert the sum of the first and second mortgages in the numerator. Similiarly, if the borrower is applying for a third mortgage, then the underwriter should insert the sum of the first, second and third mortgages into the numerator.

When the borrower is applying for a second or third mortgage, the loan-to-value ratio is often known as the combined loan-to-value ratio (CLTV ratio).

Now let's look at the denominator. Generally the fair market value of a property is determined by an appraisal. There is one important exception, however. When the proceeds of a mortgage loan are used to buy the same property that is securing the loan, then that mortgage is known as a "purchase money loan." If the appraisal comes in lower than the purchase price in a "purchase money" transaction, then the lender will use the LOWER of the purchase price or appraisal.

Mortgage brokers 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. This may be so (although generally untrue), but lenders always base their maximum loan on the lower of purchase price or appraisal. The lender's argument (its 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."

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 she owns her own home, the total of the following -

Monthly Housing Expense

You will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While P.I.T.I. 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.

Debt Service Coverage Ratio (DSCR)

The most important ratio to understand when making income property loans is the debt service coverage ratio. It is defined as:
DSCR = Net Operating Income (NOI) / 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 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

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
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139

Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14

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.

 


THE DEBT TO EQUITY RATIO
When you apply for a loan or line of credit, this will be one of the first ratios that your banker will look at. In essence, it tells the bank how much money you have invested into your business, for every dollar of debt that lenders have put in. To calculate your debt to equity ratio, you divide your total liabilities by the owner's equity:

                                 Total liabilities
                                 ____________

                                 Owner's equity

Debt to equity ratio example: Company ABC, which has been in operation for five years, currently has total liabilities of $125,000 and their owners' equity is $75,000.

$125,000
_________
$75,000 		=1.67
Ideally, the banks want to see a ratio of 2:1, which equates to a 2.0 or less. As your ratios edge above this level the loan becomes a riskier proposition for the bank, and there is a good chance that your credit application will be declined.  

CURRENT RATIO
The current ratio tells a lender about the liquidity of your assets, and as a result it says a lot about your ability to pay your short term debts. To calculate your current ratio, your current assets are divided by your current liabilities:

                                                      Current assets
                                 _______________
                                   Current liabilities

Current ratio example: Company ABC has current assets of $75,000 and current liabilities of $60,000, so their current ratio is:

$75,000
_________
$60,000 		=1.25
 

DEBT SERVICE OR COVERAGE RATIO
The coverage ratio is an indicator of your company's ability to pay its overall debts. This ratio is calculated by dividing your net operating income by your total debt service:

                                         Net Operating Income 
                            _________________
                              Total Debt Service

Coverage ratio example: Company ABC has a net operating income of $185,000 and a total debt service of $100,000:

$185,000
________
$100,000 		=1.85
Ideally, you want your coverage ratio to be over 1.0, as this indicates that your operating income is sufficient to cover your total debt service.    

THE TIMES INTEREST EARNED (TIE) RATIO Like the debt service ratio, TIE may be used by bankers to assess your ability to pay your liabilities. The TIE ratio determines how many times during the year your business has earned the annual interest costs associated with servicing its debt. To calculate your TIE, you must divide your profit before interest and income taxes by the total interest charges:

                                      Profit before Interest and Taxes 
                         ___________________________
                                 Total Interest Charges

TIE ratio example: Company ABC's profit before interest and taxes is $22, 000 and its total interest charges are $10,000:

$22,000
_________
$10,000 		=2.2
Your banker will be looking for your TIE ratio to be 2.0 or greater, showing that your business is earning the interest charges two or more times each year.      

THE QUICK RATIO
Also known as the Acid Test or Cash Ratio, bankers use this ratio to determine how quickly you would be able to pay off your current liabilities if you needed to convert your "quick" assets into cash. This ratio differs from the Current Ratio in that it excludes inventory. The logic behind this is that while inventory may have been paid for and has value, it may not necessarily be converted into cash quickly.

Calculation method #1:

                                      (Total current assets – current inventory)
                                      __________________________________
                                                            Current liabilities

Calculation method #2:
Since the purpose of this ratio is to exclude inventory, it can also be calculated by adding Cash and Convertibles and other Current Assets (that exclude inventory and prepaid items), and dividing that by the Current liabilities:

              (Cash + Convertibles + other Current Assets (excl. inventory,

                                                        prepaid items) 
           ______________________________________________________
                                                      Current liabilities  

Quick ratio example, using method 1: Company ABC's total current assets are $75,000, and its current liabilities are $60,000. It's current inventory is valued at $8,500, which gives it a quick ratio of:

($75,000 - $8,500)
___________
$60,000 		=1.11