Commercial real estate financing for income producing properties is a little different from residential real estate financing. In residential financing, the bank looks toward the borrower’s income as the primary source of repayment on the loan. With commercial financing, the bank looks first at the property’s income as the primary source of repayment on the loan.
When a bank finances commercial real estate, like an apartment building, that lender generally has two tests to determine how much they can lend on a building, the LTV and the DCR tests. Based on the results of these two tests, they can lend a maximum of the lower of the two calculated mortgage amounts.
Loan to Value – LTV Test – The first, and simple test, is a loan to value test. For example, based on the appraised value of the apartment building, the bank can lend up to 75% of the value. Let’s say the building is worth $2,000,000, in this example the bank could lend up to $1,500,000 or 75% of the value. It’s really that simple.
But since there is a second test for the maximum amount a bank will lend, the bank needs to calculate that loan amount too. Then they pick the lesser mortgage amount of the two calculated amounts.
Debt to Income – DTI Test – The second test is called a debt-to-income test. Basically the bank will review the property’s financial statements and come up with a Net Operating Income (NOI) calculation based on actual income that the property has generated. Let’s say the NOI is $125,000 per year.
The bank wants a cushion between that $125,000 and the loan payment and that is called the debt coverage ratio (DCR). Let’s say a bank has a minimum DCR that NOI must be at least 1.25 times the mortgage payment amount. In the above $125,000 NOI example, that would mean that the maximum loan payment (annualized) could be $100,000 per year. See the cushion between the $125,000 NOI and the $100,000 mortgage payment? This hopefully insures that if the bank takes back ownership of the property, the income off the property will service the loan payments.
With a $100,000 maximum annual mortgage payment allowed under the DCR analysis, and let’s say for illustration purposes a 5.00% interest rate on a 25 year amortizing loan, that means the maximum mortgage amount would be calculated as $1,409,000.
So under the LTV test above, the loan could be $1,500,000. Under the DCR test, the loan could be $1,409,000. And since banks want to be conservative in their lending, the maximum amount they will loan is the lower of the two, or the $1,409,000.
So what’s the actual loan to value allowed? If we divide the $1,409,000 by the $2,000,000 property value, we get an LTV of 70.45%.
Finally, different banks may have slightly different DCR’s, like 1.2, or 1.35, and different types of commercial properties also may have different DCRs, like an office building versus a retail center. Check with your lender for details and always shop a few lenders to find the best deal.
Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.