Commercial loans are appraised and underwritten differently from smaller residential income properties (1–4 units). Lenders do not use debt-to-income ratios (DTI).
Both the appraisal and the underwriting will be done largely on capitalization of income. First, let’s define a capitalization ("cap") rate for those readers who may not be aware of the term.
When we evaluate income property, we first reconstruct the income and expenses. We’ll look at scheduled market rental income and subtract a reasonable market vacancy factor. The resulting number is called Effective Gross Income. Next, we’ll reconstruct operating income for the property. We will include a management fee, even if one is not currently being charged, and standardized factors for repairs and replacements. We’ll subtract those expenses from the Effective Gross Income to get Net Operating Income (NOI). The NOI does not include depreciation or debt service.
An appraiser will use a market cap rate for the type of building he is appraising and work backward, dividing the NOI by the cap rate. A building with NOI of $100,000 in an area where the typical cap rate is 7.5% would have a derived value of $1,333,333 (100,000 / .075 = 1,333,333).
The lender will base their loan partly on "debt service coverage." This means that they’ll expect a certain amount of cash flow left over after the debt service. They will use the calculated NOI to arrive at that number. If their guidelines specify debt service coverage of 1.2, that means that our building with NOI of $100,000 would support annual debt service of $83,333 (100,000 / 1.2 = 83,333). Working backward from the annual debt service and using the loan terms available, we’ll get the size of the loan (with some possible limitations).
Annual debt service of $83,333 represents a monthly payment of $6,944. If the lender is willing to make a loan with a 5% interest rate amortized over 25 years, you’d have a loan of $1,188,000 (trust me on this. I know things). So working backward to check our work, we divide the $83,333 annual debt service into our NOI of $100,000, and we get 1.2.
These kinds of loans are almost always "portfolio" loans. This means that the lender will not sell them on the secondary market (Fannie Mae and Freddie Mac are among the largest buyers of residential mortgages), but will hang onto them. Because of this, they have the flexibility to set their guidelines. They will typically do two additional things with their loans: they will extract a personal guarantee, and they will have a maximum loan-to-value ratio (LTV) for their loans. If their maximum LTV is 80% (which is typical), the loan we’ve just calculated would be good for a property valued at $1,485,000 (1,188,000 / .80 = 1,485.000). If the property you are considering has a price lower than that, let’s say $1,300,000, the lender is likely to approve you for $1,040,000–80% of the purchase price. If your personal financials look good, some lenders may be willing to extend more credit. They might look at "cross-collateralization," for example. This means that they would encumber other properties you own to secure the excess. They may also make the loan "recourse." This means that in the event of foreclosure, they would have the right to come after you personally for any shortfall if the property should not bring in enough cash at sale to clear the mortgage and costs of foreclosure. This personal guarantee can make refinancing or selling those other properties difficult.
The primary things to keep in mind with commercial financing is that the lender is looking very hard at the economic viability of the property when approving a loan.
I hope this was useful.
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Roxy Redenbaugh, Broker
Sr Mortgage Consultant
Residential and Commercial
The Greatest Compliment I Can Receive Is A Referral From Friends, Family, and Business Associates,
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