Learn the Three Ratios That Are Used to Determine Commercial Lending
Updated: Jan 3
Getting money for your commercial project can be quite a challenge if you do not know how to analyze and present the property properly to a commercial real estate lender. Before presenting your property to a potential lender it is important to determine the most probable ratios that the lender is going to use in making a decision to lend you the money.
There is an increased risk with commercial real estate loans because of the size of the loans. Hundreds of thousands to millions of dollars are loaned on commercial properties and projects. A commercial lender wants to make sure that he or she will get their money back from the generated income of the property.
Most lenders will use the following three ratios to determine if they will loan the money on a project.
The first ratio is the debt service coverage ratio or DSCR. The DSCR applies to the property itself and how much income it is producing compared to the debt service, or how much money is paid out towards the mortgage on a monthly basis. It is expressed by the net operating income divided by the total debt service.
The net operating income is the total income left over from the property after paying all the operating expenses. The debt service is determined by the mortgage terms, such as interest rate, length of the loan, and how often a payment is made. The higher the DSCR, the more ability the property will have to cover the debt service. Many lenders require a DSCR above 1.2 in order to consider it a relatively safe investment. Anything below that indicates that the property is either barely breaking even or losing money. A lender does not want to loan money on a project that is not able to cover its debt service.
The second ratio is the loan-to-value ratio. This is expressed by the total loan balances (sum of all mortgages) divided by the market value. When you apply for a commercial loan, as you do for a residential loan, you must determine how much value of the property you are actually borrowing versus what will remain as equity. If you can acquire a loan-to-value ratio of 75%, then that is generally a good number.
If you can get more than 75% of the value loaned to you, then consider that a bonus. Lenders rules and guidelines may differ greatly depending on how much they are willing to risk on the project.
The third ratio is the debt ratio. For smaller commercial projects commercial lenders may require that you submit personal information to back the loan. This includes your personal income and debt on a monthly basis. The debt ratio is expressed by dividing monthly housing expenses by gross monthly income.
The results show how much debt stands in relation to income. Many commercial lenders will not accept a debt ratio greater than 25%. However, some commercial lenders have been known to go up to 28% or even 36%. A debt ratio greater than 25% stands a good chance of having budget problems.
The lower debt ratio you have, the more likely you will be able to get funding for your smaller commercial project.
Before approaching any lender, it is really important to analyze these ratios on your own. They pertain to your specific deal for which you want to get financing. By performing the ratio analysis on your own, you can better determine if financing will be easy or difficult to obtain, depending on the nature of the project and its level of risk.
It may be a good idea to contact several potential lenders and ask them their basic criteria and guidelines that they follow in evaluating properties. You may find that some lenders are far more conservative than others.
By understanding your property, you can better fit a lender to your specific needs. Also remember that private lenders can be extremely helpful with those risky deals that public lenders will not even consider. Be sure that you are well equipped with the proper information and supporting documentation no matter what lender you approach.