Investment Properties – Loan-to-Value (LTV) Vs Debt-Credit-Ratio (DCR) And What Has Changed?

We are seeing signs that the commercial real estate market has bottomed out as users and investors cautiously begin buying value added commercial/industrial properties. However, lenders are taking a very conservative approach in underwriting these deals in today’s volatile real estate market.

Loan-to-Value (LTV) continues to play an important role in determining the loan amount and down payment required for the purchase. The appraiser plays a key role in assessing the value of the property and ultimately the loan amount. Traditionally, users/companies can expect to buy a property with as little at 10% down or a 90% LTV and investors can expect to put down 25 – 30% or a 70 – 85% LTV. This has not changed and is still the case today.

Users/Companies continue to gravitate towards SBA financing (Small Business Administration loans) which allows them to obtain a conventional loan at an 80% LTV with the SBA loaning 10% in a second position and the borrower having to put down only 10%. Obviously the company’s financials are heavily scrutinized and anyone owning more than 20% of the company must personally guarantee the loan. This has been and is still the case today.

Investors are having a much more difficult time obtaining loans to purchase income producing properties. Lenders do factor in the Loan to Value (LTV’s) on these loans as well as the investor’s financial wherewithal, but the biggest concern is with the property’s ability (income) to afford the loan payments. Debt Coverage Ratios (DCR’s) are now at the forefront in determining how much the lender will loan on the property.

In the past DCR’s were used to determine the loan amount for income producing properties but lenders were less stringent in allowing investors/borrowers to make an argument for future income (actual rents vs. market rents) in determining NOI (Net Operating Income). This, coupled with rising property value, had both appraisers and lenders being overly aggressive in projecting a property’s market value in which to base the LTV and that is what ultimately resulted in a lot of nonperforming loans you see today.

Case Study:

Earlier this year we recently represented an investment group buying an industrial building leased to a food processing company in the Vernon, California market. This is a single tenant building with a ten year NNN lease. The annual NOI (net operating income) was $141,000 with fixed rental increases every 12 months. The property was showing an 8% return based on a $1.74 million purchase price. The investment group had budgeted 25% down or 85% LTV.

The Lender analyzed the property in the following manner to determine the loan amount:

Gross Rents of $141,000
Less Vacancy of 10% or ($14,100)
Less Reserves of 3% or ($4,230)
Less Management of 3% of ($4,230)
Property Taxes to be paid by tenant
Property Insurance to be paid by tenant
Total Expenses ($22,560)
NOI was now calculated to be $118,440
A Debt Coverage Ratio (DCR) of 1.2 was applied to the NOI
Calculated Debt Service NOI / DCR = $98,700

The lender told us this property would support $98,700 or $8,225/mo in debt service. With interest rates near 6% and a 25 year amortization this translates into a loan amount of $1.27 million. When subtracted from the $1.74 million purchase price the investor can expect to put down $470,000 or 27% of the loan amount.

When the real estate market was at or near its peak in 2007, we were seeing capitalization rates (return on investment) hovering around 5.75 – 6%. It’s easy to understand why lenders had to circumvent the DCR method in calculating the loan amount in order for a property to achieve a 75% LTV:

If you take this same property at a 6% return (or $104,400 NOI) and applied the same underwriting criteria you would have the following:

Gross Rents of $104,400
Less Vacancy of 10% or ($10,440)
Less Reserves of 3% or ($3,132)
Less Management of 3% of ($3,132)
Property Taxes to be paid by tenant
Property Insurance to be paid by tenant
Total Expenses ($16,704)
NOI was now calculated to be $87,696
A Debt Coverage Ratio (DCR) of 1.2 was applied to the NOI
Calculated Debt Service NOI / DCR = $73,080

At $73,080 (or $6,090/mo) in debt service based on a 6% return and a loan amortized over 25 years, it equates to a $945,209 loan amount. This would require the investor to put down $794,790 which is a 46% LTV.

In this instance, investors were unwilling to put 46% down and would make the argument that in the near future the $118,440 NOI (as stated above) was achievable. Lenders wanting to make the loan would buy into this argument allowing in part the DCR to be applied to the increased rents. The appraisal report would support this amount by using comparable sales to users, not investors to support an 85% LTV. Lenders would make the loan with an investor allowing them to only put 25% down when in reality they should have put 46% down as stated above. As lease rates and property values continued to plummet, these same properties no longer cash-flowed. With only 25% invested in a property that lost as much as 50% of its value we can see why so many investors walked away from their loan commitments.

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