When it comes to determining the maximum loan available for your commercial property, two of the most important calculations are the loan-to-value (LTV) and the debt service coverage ratio (DSCR). These ratios work together to determine the maximum loan amount.
We’ll start with the LTV ratio, which is easy to understand: it is the amount of the loan divided by the appraised value of the property. The maximum LTV can range from 65% to 85% depending on the asset type and the borrower’s history. The LTV in urban markets and low cap rate transactions tend to be constrained by DSCR and the maximum loan to value is often not met because of the DSCR required to qualify for the financing.
On the flip side of the coin, the DSCR is the annual net operating income (NOI) divided by the annual mortgage debt service. A lenders DSCR requirement can range from 1.20 to 1.50, but is most commonly 1.25, and is used to determine how large of a commercial loan can be borrowed based on the cash flow of the property. A lender is essentially saying they need you to have 25% more NOI than the annual mortgage payments.
In simple terms, the DSCR measures risk of a property; the ratio is set at a point where the borrower is still able to remain profitable even if they experience short term changes in the property’s income or expenses throughout the life of the loan. Oftentimes a commercial lender will add a covenant into the loan agreement that requires the borrower to maintain their DSCR at all times during the term, which can be proven by submitting operating statements either quarterly or annually.
All conventional lenders maintain a required minimum DSCR, and if the loan doesn’t meet that requirement, adjustments will need to be made to the loan amount and more cash will be required in the deal. Let’s look at an example of loan terms to understand how these ratios impact one another.
Let’s say a lender’s maximum LTV is 75% but they require a 1.25 DSCR. On the left, you see a property that simply calculates the loan based on the LTV. The total is $15,000,000 but the DSCR is 1.16. The loan on the right is $14,000,000 rather than $15,000,000, thus requiring $1,000,000 more down on a purchase or $1,000,000 less in cash out. It hits the required 1.25 DSCR but is only 70% LTV.
NOI Cap Rate Property Value Loan Amount Rate Amortization (Yrs) Loan To Value DSCR Annual Mortgage Payment | $1,000,000 5% $20,000,000 $15,000,000 4.00% 30 75% 1.16 $859,347 | | NOI Cap Rate Property Value Loan Amount Rate Amortization (Yrs) Loan To Value DSCR Annual Mortgage Payment | $1,000,000 5% $20,000,000 $14,000,000 4.00% 30 70% 1.25 $802,058 |
As you can see in the above example, the DSCR is only 1.16, too low for most lenders, therefore the LTV rate must be adjusted by the borrower bringing more money to the table for a down payment.
The debt service coverage ratio can be challenging. Taking the time to understand the way a lender underwrites your loan can save you a great amount of time and disappointment. This highlights why it’s so important to use a qualified mortgage banker who will take the time to give you accurate feedback and have a wide range of contacts to help you find the best loan terms and rate. Get in touch with me today if you’re interested in learning more about the services I provide through Gantry.