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Understanding the math behind commercial mortgage underwriting

By Stephen A. Sobin, president & founder, Select Commercial Funding LLC

Almost every day, I am asked why some commercial mortgage loan requests are easily approved while others are rejected.

Photo by GotCredit/ Flickr

Photo by GotCredit/ Flickr

As a commercial mortgage broker with over 30 years of commercial mortgage lending experience, I have reviewed and underwritten thousands of commercial loan applications.

Underwriting is not a mystery – there is a mathematical approach that all commercial mortgage lenders utilize.

Borrowers seeking commercial mortgage loans or apartment building loans to refinance or purchase a commercial property or apartment building need to understand how commercial mortgage lenders value commercial properties and determine cash flow.

Banks and other conventional lenders (as opposed to hard money lenders or bridge lenders) are driven by a commercial property’s ability to generate cash flow and adequately service the anticipated mortgage payments. Understanding the math behind the underwriting will mean the difference between an approval and a rejection.

In order to get started with our analysis, let’s look at a hypothetical apartment building with 50 rental units.  The average rental is $1,200 per month.  Let’s create and review a sample pro-forma operating statement:

Potential gross income              $60,000/month  or  $720,000/year

Less: Vacancy allowance (say 5%)                                $36,000

Effective gross income (EGI)                                        $684,000

Less: Expenses

Management (say 5%)                                                              $34,200

Real estate taxes                                                                        $80,000

Insurance (estimated at $300 per unit)                               $15,000

Repairs and Maintenance (estimated at $750 per unit)   $37,500

Utilities                                                                                        $120,000

Misc. (estimated at 2% of EGI)                                              $13,680

NET INCOME                                                                     $383,620

In our example, this property has a net operating income of $383,620 after operating expenses (but before mortgage payments).  This is the most important number to a commercial mortgage underwriter as this figure will determine the value of the property and the ability of the property to support the mortgage payment.  Let’s continue with our analysis:

As outlined above, this property has a Net Operating Income (NOI) of $383,620.

An investor who purchases this property will earn a return of $383,620 on his investment.

What is the relationship between the NOI and the property’s value?  The answer will introduce the next concept, which is the Capitalization Rate, or Cap Rate.

The cap rate is the percentage return that an investor expects to earn on his investment.

A bank account today will have less than a 1% cap rate as bank deposits today pay very little interest.  A treasury certificate will have a 2%-3% cap rate.  Investors investing in real estate should earn higher yields than these safer investments.

A property owner usually expects to earn a return of 5%-10% on his investment depending upon the risk.  If an investor earns, say, 8% on his investment, we say that the property has an 8 Cap.

The net operating income is divided by the cap rate to determine the value of the property.

Continuing our analysis of the property above, a property that nets $383,620 and yielding an 8% return on investment will have a value of $4,795,250 ($383,620 divided by 0.08 = $4,795,250).

If the investor is willing to accept a lesser return of, say, 6%, the property is now worth $6,393,667.

As you can see, the lower the expected return, the higher the value.  Or said in another way, the more you pay for a property, the lower the return on investment.

Each type of property and each individual market will determine the cap rate used.

For example, a luxury apartment building in Manhattan will have a lower cap rate (and hence be more expensive) than a lower income property in the Bronx.  If you are buying an apartment building, make sure you calculate the net operating properly, be knowledgeable about market cap rates (by speaking with knowledgeable local professionals), and determine an appropriate selling price before making an offer.

Once we determine the NOI and the cap rate, we need to calculate the Debt Service Coverage Ratio or DSCR.

The DSCR is the ratio between net operating income and the annual mortgage payments (called Debt Service).  Notice that in the example above we did not list mortgage payments as expenses.  How much of a mortgage can this property support?

A typical lender will look for a DSCR of 1.25 or better.  That means the NOI divided by the Annual Mortgage Payments should be at 1.25 or better.  Said differently, the NOI needs to be at least 25% greater than the payments.  Let’s illustrate this point:

We start with our NOI of $383,620.  Dividing by 1.25 gives us the maximum annual debt service of $306,896 or $25,575 per month.  This means that our proposed mortgage payment must not be greater than $25,575 per month.  If we use an interest rate of 4.00% and a 30-year amortization, we come up with a maximum loan amount of $5,356,971 as the maximum loan amount an underwriter will consider using the DSCR method.

Next, we need to calculate the proposed Loan to Value Ratio or LTV.  The LTV is a common ratio that most investors are already familiar with, and is defined as the loan amount divided by the property’s value.  Many commercial mortgage lenders will lend up to 80% LTV.

Again, illustrating from our example above, if the property appraises at $6,393,667 (using a 6 cap), an 80% LTV will yield a maximum loan of $5,114,934 ($6,3963,667 x 0.80 = $5,114,934).

In most cases the maximum loan calculated by the DSCR method will differ from the maximum loan amount as calculated by the LTV method.  The lower number will always be used, and in this case, the maximum loan amount will be as determined by the LTV method at $5,114,934 versus the $5,356,971 as calculated by the DSCR method.  In this example, we say that our loan is “LTV constrained” since the loan amount is limited by the LTV and not the DSCR.

There is no mystery when it comes to approving commercial mortgage loans.

Underwriters employ very specific formulas to determine net operating income, cash flow, debt service coverage ratios and loan to value ratios.

Borrowers who understand these calculations and are able to present an accurate loan summary to a commercial mortgage lender stand the best chance of having their commercial mortgage loan approved.

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