If you are a homeowner, you know the basics of underwriting a single family residence. The lender’s emphasis was placed on your creditworthiness. If your creditworthiness passes muster, the property is evaluated to see if it is a viable investment. It’s fairly simple right? But what do commercial real estate lenders look for?
Underwriting requirements for commercial real estate lending are much different. The lender’s focus will shift more to the prospective rental property rather than the buyer’s personal credit. Why is that?
Well, as they say, follow the money. The emphasis on cash flow, which determines the ability to pay, turns from the borrower’s cash flow in lieu of personal income to the property’s cash flow in lieu of income production. The borrower’s credit worthiness is still vetted but the real emphasis is on the prospective property. Here is a simplified version of the process.
Lenders dig deep into the history of the rental property. To do this, the underwriter will consider the property’s Net Operating Income, Capitalized Value, and Debt Service Coverage Ration to determine the creditworthiness of the property. We’ll look at each of these.
Net Operating Income, or NOI, is the Effective Gross Income minus Operating Expenses. EGI is the income brought in by the occupied rental units. Rent rolls are used to calculate this figure. Rent rolls are calculated by totaling all potential rent collection on each unit, occupied or not. After the annual EGI is calculated, it’s time to look at annual operating costs. Operating costs would include things such as real estate taxes, maintenance and repair, insurance, management fees, etc.
To illustrate, we’ll use a ten unit property that was 90% occupied last year with each unit paying $1,300 a month. The property’s Gross Effective Income was $140,400 last year. The operating expense was $68,724. This makes the property’s NOI $71,676. Next, we’ll calculate the property’s Capitalized Value.
Capitalized Value is a ratio of the building’s purchase price compared to the cash it makes. It measures your investment’s performance. Cap Value = NOI / Purchase Price. If the NOI was $71,676 and the property was purchased for $1,000,000 then our Capitalized Value is 7.2%. The current average annual Capitalized Value of an investment property in the U.S. is 7.5%. This leaves us with the DSCR.
Debt Service Coverage Ratio is the percentage of the NOI that exceeds the properties annual debt service. Debt service is the cost of the mortgage. Lenders typically lend at 75% Loan to Value on multi-family commercial property. This makes our loan amount $750,000. If your mortgage interest rate is 6.5% on a 30 year fixed loan, the annual debt service is $56,886. The DSCR = NOI ($71,676) / debt service ($56,886). This would make the DSCR 1.26%. Most lenders are requiring a DSCR of 1.25% or above so this would be adequate.
There are a few more details that the lender will analyze but these are the most important ones. If these cash flow indicators meet the lender’s standard, and your personal creditworthiness is sufficient, you are on your way to owning a solid real estate investment. It’s not time to sit back and rest on your laurels though. Now it’s time to look for ways to improve the cash flow of your new investment… stay tuned.