RATIOS:
Ratios are an important factor in calculating the risk of a commercial loan. There are a number of ratios used in underwriting a commercial loan, but the ratios discussed below are the most commonly used and easy to understand.
- Loan to Value Ratio – LTV: Total loan balance (1st mtg.) / Property Value (the lower of appraised value or purchase price)
- Example: A building has appraised for $1,000,000.00, and the purchase price is the same. There is proposed financing for a first mtg. of $500,000.00
- $1,000,000.00 / $500,000.00 = .50 OR 50% LTV
- Combined Loan to Value Ratio – CLTV: Total loan balances (1st mtg. + 2nd mtg.) / Property value (the lower of appraised value or purchase price)
- Example: A building has appraised for $1,000,000.00, and the purchase price is the same. There is proposed financing for a first mtg. of $500,000.00 and a second mtg. of $400,000.00
- $1,000,000.00 / ($500,000.00 + $400,000.00) = .90 OR 90% CLTV
- Debt Service Coverage Ratio – DSCR or DCR: This ratio is usually only used for commercial loans. Defined as: Debt Service Coverage Ratio = Net Operating Income / Debt Service.
- Example: A company has a Net Operating Income of $100,000.00 per year, and proposed financing for $80,000.00 per year or $6,666.66 per month. $100,000.00 / $80,000.00 = 1.25
- A debt service coverage ratio of less than 1.0 would mean that the property did not produce enough income for the owner to make the mortgage payments without supplementing the property from his/her personal budget.
- 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 debt service.
- Net Operating Income = Gross Scheduled Rental Income
Less 5% Vacancy and Collection Loss
= Effective Gross Income
Less Operating Expenses
(Real Estate Taxes, Insurance, Repairs and Maintenance, Utilities, Management, Reserves for Replacement)
= Net Operating Income (NOI)
Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate in an area to cover for collection loss… typically 5%. 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. ALSO, please note that we have not included loan payments as an operating expense
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