The commercial corner: Determining debt-service coverageMike Boggianodebt-service coverage, small commercial loans The Mortgage Press is pleased to present "The Commercial Corner," a monthly column by Mike Boggiano of Silver Hill Financial LLC, dedicated to answering your questions about the commercial mortgage marketplace. If you have a question that you would like answered in a future installment of "The Commercial Corner," please e-mail [email protected]. Perhaps the biggest difference between residential and commercial lending is the underwriting used to determine loan financing. Everyone is familiar with the debt-to-income (DTI) approach used for residential mortgages. Many brokers new to commercial lending, however, are not familiar with the commercial method that looks at the property's debt service. Knowing how it's calculated can help you feel more comfortable working with commercial deals. Q: How different is commercial underwriting? A: You might think of it this way. Residential underwriting focuses on the borrower's ability and willingness to repay the loan, while traditional commercial underwriting examines the property's ability to repay the loan. Fundamentally, these are very different methods, and commercial transactions are certainly more complex than residential mortgages. Most traditional commercial lending programs focus on underwriting only the subject property, using the conventional debt-service coverage ratio (DSCR). With this type of commercial loan, individualized deals and a non-standardized process are common. Lead times are noticeably longer than residential transactions (varying widely, from 90 to even 180 days in some cases), with more stringent appraisals and documentation requirements. In addition, borrowers are often subject to the whims of credit committees that determine whether the loan will pass. Q: Can you tell me how to determine debt-service coverage? A: DSCR is calculated by taking the underlying property's net operating income (NOI), which is gross monthly rents minus monthly operating expenses, and dividing by the debt service (the subject property's monthly mortgage payment, including principal and interest). This calculation shows the property's ability to repay the loan. Generally, traditional lending institutions look for a property to generate at least $1.20 in NOI, or cash flow, for every $1 of the proposed mortgage debt, or debt service/payment. If the ratio falls short, they most often will pass on the loan. Keep in mind that the target number may vary by lender. The higher the ratio is, the greater the perceived likelihood that the loan will be repaid will be. The property must generate more than enough income to pay the mortgage, insurance, taxes, maintenance and operating expenses incurred. Q: Another term I've heard is "cap rate." What is it? A: "Cap rate" is short for "capitalization rate," and it is the ratio used to convert a single year's NOI to an indication of value. This is generally extracted from the market by getting the NOI from recent transactions and dividing by their respective sales prices. Put another way, the cap rate is an indicator of value in a given market - the demand for a particular real estate product. When property values are high, cap rates are low. The two values are inversely proportionate. While NOI is constant with a commercial property, the variable that affects property value is the cap rate (the market's required return). For example, a property generating NOI of $100,000 at a 10 percent cap rate would be worth $1 million. In a hotter real estate market where similar properties are trading at an eight percent cap rate, however, the same property would value at $1.25 million. This example illustrates that a seemingly small adjustment in cap rate can have a major impact on value. A half-percent difference would alter the value by nearly $50,000. In markets where real estate values are on the rise or characteristically high, it is very difficult for properties to generate enough cash flow to support a higher loan-to-value (LTV). The higher the LTV is, the higher the debt load will be and the harder it will be for rents generated to carry a high mortgage payment plus related property expenses. However, the same scenario under a debt-to-income analysis (see next question) may yield an approved deal based on the borrower's DTI ratio, even allowing for 90 percent LTV in some casessomething generally impossible when relying on the property's debt service. Q: Is there any way to get around debt service on small commercial loans? What if the borrower has really good credit? A: Until a few years ago, even borrowers with great credit were fairly limited in terms of options. However, with the introduction of residential-style underwriting being applied to small commercial loans, borrowers have an alternative to bank financing that is ideal for small-balance loans. In other words, programs that focus on the borrower's personal financial strength rather than just that of the property are available in the marketplace. Working with such a program, brokers are able to attract borrowers that previously may not have known how to obtain a commercial loan. Small-business owners, professionals with their own practices and first-time and seasoned investors find the DTI-style commercial loan an attractive option. This type of program avoids the large-balance mentality that many traditional lenders have toward any size commercial deal and speeds the process by taking a more commonsense approach to financing, environmental issues and other areas of the transaction. Be aware, however, that even those offering small-balance products may still utilize conventional commercial methods. Mike Boggiano is senior vice president, national sales manager for Silver Hill Financial LLC. He may be reached by phone at (877) 676-1562 or e-mail [email protected].
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