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
Repairs & Maintenance
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
$500,000 First Mortgage
7.5% Interest, 25 years amortized
Annual Payment (Debt Service) = $44,339
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
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.
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.
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:
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
- Top Debt Ratio
- Bottom Debt Ratio
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 "bottom" debt 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:
- 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)
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%.
- 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.