Understanding Loan to Value, Loan to Cost, Debt Yield, Debt Service Coverage Ratio and Loan Constant
This final installment of the Metrics That Matter series relates to debt financing metrics. One of the great advantages of commercial real estate investment is the ability to use debt to finance a large portion of an asset’s purchase price (leverage), and to try to use the debt to increase the overall returns of the project (positive leverage).
To analyze the debt available for an asset, commercial real estate lenders look at the existing and future expected cash flow of a property to determine how much debt can be prudently lent to acquire the asset without putting the owner at risk of defaulting due to a future inability to repay the mortgage.
The following provides the top lending metrics that investors and lenders alike look at when determining the maximum debt a property can support now, and in the future. Some metrics are used purely for when an asset is stabilized and appreciation is expected to match measured market growth, while other metrics relate to a value add project that needs additional capital to become stabilized in the future.
Part Three: Lender Metrics
Loan to Value (LTV) A prudent lender will first look at the value of the real estate to determine the size of the loan they are willing to make. The value is generally determined by the lesser of the purchase price, if a purchase, or a licensed appraiser’s opinion of value in an appraisal. The loan to value (LTV) ratio is the loan amount divided by the value of the property, and generally the lender has predetermined lending ratios based upon the property type and amount of risk exposure the lender wants on a per loan basis. For example, if a lender offers 75% LTV for apartment buildings, the lender is saying they will make a loan that is 75% of the value or purchase price of the property. The owner of the real estate can expect that using this metric for a property that has a $1,000,000 value will result in a $750,000 loan, or 75% x $1,000,000. Using this loan, the property owner will only need to bring the remainder of capital, or $250,000 of equity, to acquire the transaction.
If an asset is not stabilized, a lender may choose to look at the expected income and expenses for the property and underwrite to the value of the asset once some kind of stabilization occurs. For example, a borrower purchases a property for $1,000,000, but the asset has below market rents and above market expenses, and therefore is not considered stabilized. If the value was achieving market rents with market expenses, the property may be worth $1,250,000. The lender may look to approve a loan for 75% of the stabilized value, or $1,250,000, or $937,500 (75% of $1,250,000), but likely will not provide all of the proceeds to the property owner until the asset is stabilized. In such instances, the property owner likely needs to spend some money to bring up rents and reduce expenses, so a portion of the loan proceeds will be released by the lender at different points during the initial period of the loan to help get the asset to the higher stabilized value. These additional proceeds may be called Lender Advances and would be provided to the property owner through draws from the lender.
Loan to Cost (LTC) Loan to Cost (LTC) is the metric used to determine the ratio of the total loan amount relative to the total project cost. This metric is helpful for lenders for value-add projects to make sure that the borrower of the loan is bringing actual capital to the project. For example, if an asset is purchased for $1,000,000 and the owner wants to put $250,000 in rehab dollars into the project to get to a stabilized future value of $1,750,000, if the lender uses only the stabilized future value and applies an LTV metric of 75%, the maximum loan amount would be $1,312,500 (75% of the $1,750,000 value). The issue here is the full cost of the project is $1,250,000, so using the future value alone could result in 100% of the project being financed, and the borrower having no “skin in the game” (i.e., the borrower has cash equity in the project and therefore nothing at risk, a scenario most lenders avoid). Alternatively, if only the current value LTV metric is used, a 75% LTV on a $1,000,000 current value results in a maximum loan amount of $750,000, or 43% of the stabilized future value. To solve for these too-high or too-low outcomes, many lenders will use a more common-sense methodology when value is being created, which is to look at both the future LTV and the LTC, and use the lower of the two to ensure that sufficient borrower equity is put in. If the total cost of the project is $1,250,000 and the lender uses a 70% LTC, the loan amount would be $875,000 which is higher than 70% of LTV ($750,000) but lower than 75% of the stabilized value ($1,312,500). Using a 70% LTC, it would require that the borrower brings in 30% of the total project cost, or $375,000, and reduces the lender’s exposure until the value creation occurs.
Debt Yield (DY) A purely lender focused metric is the debt yield (DY), which could be called the lender’s cap rate, because it uses the net operating income as it relates to the loan amount, instead of the value of the asset. The reason some lenders, primarily securitized lenders, use the debt yield as a lending metric is because it is essential to the lenders return if they have to foreclose on the asset right away. Consider the lender’s “basis”, or total dollars invested, as the amount of the loan outstanding on any property. If the borrower defaults the lender potentially has the ability to foreclose and take over the asset at that “price” (not inclusive of legal fees, unpaid taxes, etc.). The lender therefore will look at the current net operating income of an asset to determine what kind of return they would get if they took over the property at the loan amount. For example, if the property generates a $100,000 net operating income, and the lender has forwarded $1,000,000 of debt secured by the asset, they would have a 10% debt yield, or $100,000 divided by $1,000,000.
Debt Service Coverage Ratio (DSCR) The debt service coverage ratio (DSCR), determines how much mortgage a property can support. It is an important ratio used by lenders primarily to determine the maximum loan amount a property can support once stabilized. The ratio takes all available cash flow after expenses and divides it by the annual debt service to determine whether it meets the lenders stated requirements. For example, if the property cash flows annually at $100,000 and the monthly mortgage payment is $5,000, or $60,000 annualized, the property has a $100,000 divided by $60,000, or 1.67 debt service ratio. Consider that for every $1 of mortgage payment, the property generates $1.67 in income. Most lenders set a 1.20 to 1.25 minimum debt coverage ratio as a lending guideline to make sure the property’s income can cover the mortgage payments, and reduce the likelihood of a default. When the asset isn’t stabilized, the DSCR is useful for borrowers and lenders alike to see how much bridge or interim financing the property supports from in-place cash flow. For example, a .8 DSCR tells us that most, but not all of the mortgage payments can be paid from the property’s current tenants, but an interest reserve to cover the rest of the loan payments due will be needed to remain current on the loan until the asset is stabilized.
Loan Constant The last lending metric to look at, particularly as a borrower, is the Loan Constant. The Loan Constant takes into consideration the ratio of the total annual loan payments divided by the total loan amount to determine the percentage of the loan amount are you paying each year. The real purpose of reviewing this metric is to see the cost of the mortgage to the project and determine if the asset is positively or negatively leveraged, meaning if the cost of the debt is positively or negatively impacting the overall returns of the asset. A loan of $1,000,000 that has a 4% interest rate amortizing over 30 years has fully amortizing annual loan payments of $57,289.84 (interest and principal), will result in a debt constant of 5.73% ($57,289.84 / $1,000,000 If the stabilized cap rate of the asset is below 5.73%, the debt will negatively impact the overall return of the asset (negatively levered), but if the stabilized cap rate of the asset is above 5.73% then the overall returns will be improved (positively levered).
While the LTV, LTC, DY and DSCR are most commonly used as lending criteria, it is also helpful for investors to review these metrics as they relate to the risk profile of an investment. Projects that have high LTV (over 80%), high LTC (over 80%), low stabilized DY (less than 8%) and low stabilized DSRC (lower than 1.25) have higher risk profiles as they relate to the debt on the property, and potentially have a greater chance of default if the project doesn’t meet the underwritten expectations or hits a market bump. Although such debt terms may be reasonable for the project, it is worth understanding that there may be additional risk before choosing an investment opportunity.
Disclaimer: All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.