How Much Will A Lender Loan?
Calculating the Debt Service Coverage Ratio (DSCR)
Commercial lenders are quite careful in their underwriting. Since the personal credit histories of buyers are rarely important in commercial lending, they use other criteria to make lending decisions. Commercial property is purchased to generate income, so one of the criteria that's popular is to look at the income to see if it is enough to adequately pay the mortgage and leave a profit for the borrowers.
When a lender looks at an apartment or multifamily property, whether a mortgage will be granted, and for how much, could be determined using the DSCR, or Debt Service Coverage Ratio. It's a simple calculation, but very important. The lender isn't really concerned much with individual credit scores or histories of the owners. The investment's purpose is ROI, Return on Investment, and more importantly cash flow.
Actually, investors should value the lenders' care in making sure the cash flow calculations are correct for an apartment project. They will want to see financials that show income and expenses. They will then determine if these numbers look like they'll continue into the future, or possibly get better or worse. When the numbers show that the cash flow will adequately cover the debt service, it validates the investment selection and valuation skills of the investor(s).
While there are many places to see how to calculate the DSCR with a project and mortgage amount already in place, it is more likely a buyer will want to know how much they can borrow on a project they're considering buying. The investors do their own calculations and look to their chosen lender to validate the numbers they came up with. Both investors and lenders have a common goal in this respect. Is the project going to be profitable enough to service the debt with adequate profit left over?
We'll look at this from two directions, getting the current DSCR and evaluating a property with a lender-required DSCR. This calculation backs into that amount using a common lender minimum acceptable DSCR of 1.20. Then we'll do it the other direction, getting the DSCR.
Time Required: 20 minutes
- Determine the cash flow, or gross operating income after subtracting vacancy and credit losses. Rent totals of $187,000/year - 9% vacancy & credit loss ($16,830) = $170,170
- Then get to NOI, or net operating income, by subtracting all other expenses for operation and management, including taxes and insurance. Gross Operating Income - All Expenses = NOI, or Net Operating Income
- $170,170 - 72,470 (expenses) = $97,700 NOI
- $97,700 / 12 months = $8,142/month NOI
- If the lender is using a minimum acceptable DSCR of 1.20, then that $8,142/month would have to be 1.2 times the monthly mortgage payment. To get to that maximum payment, it is necessary to divide the $8,142 by 1.2. $8,142 monthly net income / 1.20 minimum DSCR = $6785/month maximum mortgage payment.
- Now it is only necessary to determine how much would be loaned at current rates. If this buyer can expect an interest rate of 6.875% on a 30 year loan, a mortgage calculator will tell us that the lender may be willing to loan around $1,032,836 on this property, as that loan and interest rate would result in principal and interest payments of $6785/month, and the minimum 1.20 DSCR. Most mortgage calculators will let you enter the payment, interest rate, and time to calculate loan amount.
- When we started, we knew we were backing into a mortgage amount using a stated DSCR, as we are buyers wanting to estimate how much could be borrowed to mortgage a property we're evaluating for purchase. But, let's just do a DSCR calculation where we know the current project's expenses and mortgage payment. $223,000 NOI / $172,000 Annual Mortgage Payments = 1.30 DSCR
- 1.3 is better than 1.2 in this case, so probably an acceptable DSCR. However, if a new loan is being sought on an operating project, current NOI would be used as we did at first to see what might be available as a mortgage amount.
When the numbers work, investors and lenders can feel good about the project funding and future profitability.
What You Need:
- The income & expense details for the property.
- A mortgage calculator.