Most of real estate lending can be boiled down to the results of three ratios:

• loan-To-Value Ratio
• Debt Ratio
• Debt Service Coverage Ratio (DSCR)

The bulk of the energy spent "processing" a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the above 3 ratios.

The Loan-To-Value Ratio (LTVR) is defined as follows:
Loan-To-Value= Total loan balances (1st mtg+2nd mtg+3rd mtg) / Fair market value (as determined by appraisal)
Loan-To-Value Ratios seldom exceed 80% because the lender always want some extra protection against default.

The second ratio that lenders use when underwriting a loan is the Debt Ratio. The Debt Ratio compares the amount of bills that the borrower must pay each month to the amount of monthly income he earns. More precisely, the Debt Ratio is defined as:
Debt Ratio = Monthly Debt Obligations / Monthly Income

Obviously someone whose Debt Ratio is 150% is in trouble. A Debt Ratio of 150% would mean that a borrower's obligations are one and a half times his income. Debt Ratios seldom are allowed to exceed 40% in practice.

The final ratio used in lending is the Debt Service Coverage Ratio (DSCR). The Debt Service Coverage Ratio is a sophisticated ratio only used for large loans on income producing properties. It is defined as:
Debt Service Coverage Ratio = Net Operating Income / Debt Service

Net Operating Income is the income from a rental property after deducting for real estate taxes, fire insurance on the property. Most lenders insist that this ratio exceed 1.0. A debt service coverage ratio of less than 1.0 would mean that the property did not produce enough net rental income for the owner to make the mortgage payments without supplementing the property from his personal budget.

Commercial Loan-To-Value Ratios

The loan-to-value (LTV) ratio is probably the most important of the 3 underwriting ratios.

The loan-to-value ratio is defined as:
LTV Ratio = Total Loan Balances (1st mtg + 2nd mtg + 3rd mtg) / Fair Market Value of the Property

First let’s look at the numerator. If the borrower is only applying for a fist mortgage, and there will be no other loans on the property, then the beginning balance of the new loan requested should be inserted in the numerator.

However, if the borrower is applying for a second mortgage, then the “underwriter” (the person who determines whether or not the loan qualifies) should insert the sum of the first and second mortgages in the numerator. Similarly, if the borrower is applying for a third mortgage, then the underwriter should insert the sum of the first, second and third mortgages into the numerator.

When the borrower is applying for a second or third mortgage, the loan-to-value ratio is often known as the combined loan-to-value ratio (CLTV ratio).

Now let’s look at the denominator. Generally the fair market value of a property is determined by an appraisal. There is one important exception, however. When the proceeds of a mortgage loan are used to buy the same property that is securing the loan, then that mortgage is known as a “purchase money loan”. If the appraisal comes in lower than the purchase price in a “purchase money” transaction, then the lender will use the LOWER of the purchase price or appraisal. 

Mortgage brokers are often asked by real estate agents and buyers to base their loan on the appraised value rather than the purchase price. Their claim is that they have negotiated a supper deal and that the property is worth much more than what they are paying for it. This may be so (although generally untrue), but lenders always base their maximum loan on the lower of purchase price or appraisal. The lender’s argument (its their money, so there is really very little argument) is that an appraisal is really no more than an estimate of fair market value, no matter how competent or conscientious the appraiser may be.  The only true indicator of value is the marketplace in which “a willing buyer and a willing seller, each in full knowledge of the salient facts, and neither under undue pressure, agree upon terms.” If the property sells for “X”, then it is probably only worth “X”.

When analyzing the personal budget of borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:

1. Top Debt Ratio
2. Bottom Debt Ratio

The “top” debt ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income

By “monthly housing expense” we mean either the borrower’s monthly rent payments, or if she own home, the total of the following –

Monthly Housing Expense

• 1st mortgage payment on home plus
• Real estate taxes (annual cost12) plus
• Fire insurance (annual cost/12) plus
• Homeowner’s association dues(if home is a condo or townhouse)plus
• Second mortgage payment (if any) plus
• Third mortgage payment (if any)

You will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While P.I.T.I. is not exactly the same as Monthly Housing Expense because it does not include homeowner’s association dues, the two terms are often used interchangeably.

Lenders have learned over the years that a borrower’s “top” debt ratio should not exceed 25%. In other words, a person’s housing expense should not exceed ¼ of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.

The second ratio that lenders use to determine if a borrower can afford her obligations is the “bottom” debt ratio. It is defined as follows:
Bottom Debt Ratio = (Total Housing Expense + Debt Payment)/Gross Monthly Income

The only difference between the two ratios is the inclusion in the numerator of “debt payments”. Debt payments include the following:

• Debt Payments
• Car payments
• Charge card payments
• Payments on installment loans, for example – a payment on a washer & dryer that the borrower purchased
• Payments on personal loans, for example – a signature loan from the borrower’s bank

Commercial Debt Service Ratio

The most important ratio to understand when making income property loans is the debt service coverage ratio. It is defined as:

DSCR = Net Operating Income (NOI) / Total Debt Service

To understand the ratio it is first necessary to understand the numerator and the denominator. Let’s take a look at net operating income (NOI) first.

Net operating income is the income from a rental property left over after paying all of the operating expenses:

Gross Scheduled Rents $100,000
Less 5% Vacancy & Collection Loss $5,000
Effective Gross Income: $95,000

Less Operating Expenses
Real Estate Taxes
Insurance
Repairs & Maintenance
Utilities
Management
Reserves for Replacement
Total Operating Expenses: $30,000
Net Operating Income (NOI)

Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate in an area to cover collection loss. In addition lenders always insist on using a management factor of 3-6% of effective gross income, even if the property is owner managed. Their logic is that they would have to pay for management if they took back the property.  Finally, NOTE THAT WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.

Next let’s look at the denominator, Total Debt Service. This includes the principal and interest payments of all loan on the property, not just the first mortgage. NOTE THAT WE HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted for above when we arrived at net operating income (NOI).

To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139

Then:
DSCR = Net Operating Income
(NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14

Obviously the higher the DSCR, the more net operating income is available to service the debt. From a lender’s viewpoint it should be clear that they want as high a DSCR as possible.

The borrower, on the other hand, wants as large a loan as possible. The larger the loan the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.

 Life insurance companies are very conservative and generally require a 1.25 or 1.35 DSCR. This means that their loan-to-values ratios are low. Savings and loans (S&L’s) generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.

A DSCR of 1.0 is called a break even cash flow. That is because the net operating income (NOI) is just enough to cover the mortgage payments (debt service).

A DSCR of less than 1.0 would be a situation where there would actually be a negative cash flow. A DSCR of say .95 would mean that there is only enough net operating income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to keep the project afloat.

Generally lenders frown on a negative cash flow. Some lenders will allow a negative cash flow if the loan-to-value ratio is less than around 65%, the borrowers has strong outside income such as electronic engineer, and the size of the negative is small. Lenders rarely allow negative cash flows on loans over $200,000.

Questions to Ask Yourself

Are you and your business credit worthy?
-Your personal and business credit ratings will be analyzed.

What kind of money for you require?
-Short, long, intermediate term money or equity capital.

Hope much money do your need?
-Present exactly what you need and what it is for.

Do you have sufficient collateral?
-Your collateral must equal the loan amount at a minimum.

What are the Lender’s rules?
-Ask about Loan to Value’s Debt Coverage Ratios.

What kinds of limitations will be set by you?
-Know your comfort level with rate, payment, and term.