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Commercial Loans
Under a credit line agreement,
the lender supplies a business with funds intended to fill temporary
shortages in cash that ar
e brought about by timing differences
between outlays and collections. Typically used to finance inventories,
receivables, project or contract related work.
Short-Term Loans
Used for
seasonal build-ups of inventory and receivables. Generally re payed in a
lump sum at maturity, made on a secured basis and are for a term of a year
of less.
Asset Based Loans
Lender advances
funds based on a percentage of your current assets. The loan is used as
source of funds for working capital needs. Lender typically takes a
security position in the assets owned by the business.
Contract Financing
Funds
are advanced to you as work is performed. Payments by the contracting
party are generally made directly to the lender.
Factoring
Factors actually
buy your receivables and rely on their own credit and collection
expertise. Essentially, your customers become their customers. Factoring
is used by firms who are unable to obtain bank financing. The cost of
financing is usually higher than other forms of S-T financing.
Term Loans
Used to finance
your permanent working capital, new equipment, buildings, expansion,
refinancing, and acquisitions. Commercial banks are the major source of
funding. The term of the loan is based on the useful life of the assets
being financed or collaterized. Your projected profitability and cash flow
are two key factors lenders consider when making term
loans.
Equipment and Real Estate
Loans
Loans are fully secured by the equipment being
purchased. Typically banks loan 60-80% of the value of the equipment and
is repaid over the life of the equipment.
Lenders make long term loans
secured by commercial and industrial real estate. The loan is usually made
up to 75% of the value of the real estate to be financed. Repayment terms
range from 10 to 20 years. Lenders also make second mortgages on real
estate. The amount of the second mortgage is based on the appraised market
value and the amount of the first mortgage.
Leasing
Can be accomplished
through a bank, leasing or finance company. Your business will be subject
to the same type of review as when seeking a loan, specifically cash flow
of company, value of lease object and useful life. Lease terms range from
3 to 5 years. At the end of the lease, there are generally 3 options:
purchase, renew and return.
3-15 YR Balloon
loans
Balloon loans offer interest rates that are fixed
for a period of years. Typically these loans are pegged to a treasury
index. Terms are for 3, 5,7,10 or 15 years. The amortization schedules are
generally for 20 or 25 years.
When a balloon loan
matures at the end of the agreed term, the remaining principle balance
outstanding is due at that time. The borrower can pay off the loan by
either selling the property or refinancing. Investment property is
typically owned for a previously defined period of time. Analyze your
investment strategy before securing a balloon. Having to redo a loan is
expensive.
Adjustable rate loans
An Adjustable
rate loan will typically fully amortize with no balloon features. These
loans may or may not have adjustment caps. The rate is determined by an
index plus a margin. The indices used are generally U.S. treasury bond
rates. Rates are adjusted at a certain point in time using either the
current rate of the index in question or the average of the index for the
prior year. In either event, the index used will correspond to the
adjustment term. If the loan is a three year adjustable, then the index
used should be the three year treasury index.
Some adjustable rate loans are fixed for an initial period of years and then will adjust after that period. For example a 5/1 adjustable is fixed for the first five years and there after will adjust each year. The index used will be the one year treasury rate.
Please note that commercial
lending is not standardized as it relates to programs and to guidelines.
Banks must meet certain federal standards, but the index, margin,
amortization, term and fees are components that are controlled by the
investor based on their risk profit analysis. Remember that this mortgage
will be the greatest expense your investment property will be responsible
for.
As such we recommend that you consult your real estate agent and your loan officer to assist in providing you with all the information needed to make a complete and accurate choice.
Commercial Underwriting Guidelines
Commercial Financing is underwritten on a case by case basis. Every loan application is unique and evaluated on its own merits, but there are a few common criteria lenders look for in commercial loan packages.
Financial Analysis
A key component in making an
underwriting evaluation is the debt coverage ratio. The DCR is defined as
the monthly debt compared to the net monthly income of the investment
property in question. Using a DCR of 1:1.10 a lender is saying that they
are looking for a $1.10 in net income for each $1.00 mortgage payment.
Typically they will determine the DCR ratio based on monthly figures, the
monthly mortgage payment compared to the monthly net income. The higher
the DCR ratio the more conservative the lender. Most lenders will never go
below a 1:1 ratio ( a dollar of debt payment per dollar of income
generated). Anything less then a 1:1 ratio will result in a negative cash
flow situation raising the risk of the loan for the lender. DCR's are set
by property type and what a lender perceives the risk to be. Today,
apartment properties are considered to be the least risky category of
investment lending. As such, lenders are more inclined to use smaller
DCR's when evaluating a loan request. Make sure that you are familiar with
a lender's DCR policy prior to spending money on an application. Ask them
to give you a preliminary review of the investment property that you want
to purchase. Information is free, mistakes are not.
Loan to Value
Unlike residential lending, commercial investment
properties are viewed more conservatively. Most lenders will require a
minimum of 20% of the purchase price to be paid by the buyer. The
remaining 80% can be in the form of a mortgage provided by either bank or
mortgage company. Some commercial mortgage lenders will require more than
20% contribution towards the purchase from the buyer. What a bank/lender
will do is subject to their appetite and the quality of the buyer and the
property. Loan to value is the percentage calculation of the loan amount
divided by purchase price. If you know what a lender's LTV requirements
are, you can also calculate the loan amount by multiplying the purchase
price by the LTV percentage. Keep in mind that the purchase price must
also be supported by an appraisal. In the event that the appraisal shows a
value less then the purchase price, the lender will use the lower of the
two numbers to determine the loan that will
be made.
Credit Worthiness
For
businesses less than three years old, personal credit of principals will
be evaluated. This may hold true for longer periods of time for tightly
held companies. For corporations, business performance and credit ratings
will be evaluated with a proven track record.
Property Analysis
Fair Market Value and Fair
Market Rent will be analyzed. Special use property may require additional
underwriting. Age, appearance, local market, location, and accessibility
are some other factors considered.
Commercial Lending 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, repairs, and all other operating expenses; and Debt Service is the mortgage payment 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 LTV Ratio
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 first 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. Similiarly, 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 super 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."
Debt Service Coverage Ratio (DSCR)
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) $65,000
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 loans 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-value 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 borrower has strong outside income such as an electronic engineer, and the size of the negative is small. Lenders rarely allow negative cash flows on loans over $200,000.