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In this video, I’m going to show you the four main criteria for underwriting commercial loans and how you can set yourself up for success when applying for a loan.
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Number one is debt service coverage ratio also known as DSCR. The formula is basically take the net operating income, whatever definition is being agreed as net operating income or NOI or net income divided into the debt service, which could be the interest payments plus the principal payment reductions. So NOI over debt service. Now having said that, I spent quite a bit of time in another video, if you haven’t watched it, please do so, specifically talking about the debt service coverage ratio. The link to that video will be at the end of this video and at the bottom in the comment section in the body of the notes. So that it is important to the bank. And you got to understand this, the bank or the lender are not the bad guys. They want to make sure that you are making a sound investment.
So think about it. The main difference between residential properties or residential real estate and commercial real estate is that commercial real estate could be income producing. So the good news for you is that has less to do with you, your ability and your personal credit and more to do with the actual income asset, the real estate asset that is able to produce enough income to cover the debt by at least 20%. It could be 25%. So it could be 1.2 or over two. It could be 1.2 over one, or it could be 1.25 over one or 1.5%. But that means that for every dollar of debt service, you need to have at least $1.20 on net income. That’s number one.
Number two, it is loan to value also known as LTV. Now the LTV answers this important question to the lender: Have you as a borrower kicked in enough equity? So as a general rule, commercial lenders will want to be somewhere between 75% and 80% with a loan against the appraised value of the property. So for instance, if the property was worth a million dollars and their rule was only up to 80%, which means that your loan will have to be about $800,000, the gap between that would be 20% which has to come from the borrower. So in this case, 20% equity is injected by you, the borrower, the purchaser of the property. And 80% would be the bank.
Now, there is one major exception to that rule and that is only when he applies to the SBA 504 program in which you only have to put down five percent and then the SBA through their formulas through this program will allow you to borrow up to 95% of the value of the property. Now, but that comes with strings attached. I’ve done several videos on the SBA 504 and the 7a program, which I really think you should watch. If you’re evaluating looking at commercial real estate and you have an issue with putting enough money down and you want to basically keep cash on your bank account, you might want to look into those loans. But that comes with the strings attached. You have to personally guarantee it, et cetera. There’s more strings attached because there’s more risk.
Think about it from the lender’s perspective. They to mitigate their risk and they do that by controlling how much exposure they have against the value of the property, because here’s the worst thing that can happen is that you default on the loan and they have to sell their property. They have to have a gap in equity to be able to be able to sell the property. So that’s number two.
Number three, cash on cash return. Also known as COCR or fancy term for return on investment. Now so what that means, the formula for that is you take the actual net cashflow or the net operating income of the property divided into the cash that you invested, that you put down. So the less cash you put down and the higher the net income, the higher the return on investment. And I’ll go into more examples at the end of the video so stay tuned.
But what’s important to know is that for you to be able to have the net operating income, you have to understand that the rental income minus the expenses, and it’s going to give you the net operating income. And then you divide that against what you put down and that’s what’s going to give you the cash on cash return, which is, for real estate investors, that’s a really big deal because if you have a limited source of funds, if you want to be able to buy a few properties, obviously the less cash you put down, that means that you’re going to have a higher cash on cash return. That’s when the property is cashflow positive. But it could also backfire because the less cash you put down, which means you’re going to have a higher mortgage payment. So I’m going to show you how that works at the end. So stay tuned. So number three was cash on cash return.
Number four. Number four is cap rate also known as capitalization rate. So those two words kind of are interchangeable. And this is very, very important when a lender is evaluating the property because it really takes… and the formula for that is you take the net operating income or the annual net cashflow of the property divided into the acquisition or the sales price of the property. Now, and the higher the cap rate, the better it is because it’s just there’s more income in which means that you’re buying the property at a lesser value. So a cap rate of 10% means that you’re earning $100,000, to illustrate $100,000 on a million dollar property. It means that the property is producing $100,000 dollars in net operating income. So cap rate is good.
Now, if we were to have $50,000 in the same $10 million property, that goes from a 10% cap rate to a five percent cap rate. So what happens in boom time is when the economy is expanding, in the major cities, what happens is you pay a premium for having stable property, a property that doesn’t have a lot of vacancies, that is constantly being a 95% plus occupancy. So investors, the hedge funds and the major national investors would be willing to trade a lower cap rate because it’s produced for a more stable property. The higher the cap rate, the more speculative the property, but there’s the better for you as the small investor. So cap rate is net operating income divided into sales price.
Everybody, I want to show you an actual example and I want to walk you through the four criteria to make sense of it with one specific example. So let’s say we’re looking at a million dollar property. And these are the numbers that we’re working with. So say, I want to look at it through the eyes of a lender and tell me if this is a good deal.
So we have a 1.5 debt service coverage ratio, which means that that is a $100,000 net operating income over a $50,000 debt service. Well, that’s sounds like a low loan. Anyway so if the debt service was $50,000 and the net operating income is $100,000, 1.5, is that good? I’d say that’s pretty darn good considering that you want to shoot for at least 1.25. I’ll always say, and I said that in my last video, that you want to shoot for higher because if something happens and if you have this property that is vacant and you lose having more occupancy, which is going to mean more, there’s going to be less than that income. So in this case, so far so good. So if I’m the bank, if I’m the lender, I’m looking at this, I’m like, “I’m feeling pretty good about that.”
Now cash on cash return. So that means that there is $100,000 worth of net income so it’s the same net income, but this time over $200,000. So you put out of cash out of pocket $200,000. So if you take the $100,000 divided into $200,000 is going to give you 0.5 or 50%. Hey, that’s pretty darn good ROI if you ask me. So it tells you I put in $200,000, on year one, you’re pocketing $100,000 dollars worth of return on investment. So cash on cash return. So that’s pretty good.
Now, the banks will look at that and they’ll say, “Yeah, that’s pretty good.” That’s more for you to know. So some people are happy to get two percent on a CD or three percent. But if you want to get higher returns, of course, you’re going to have to expose yourself to higher risk.
Now let’s go to the cap rate. And the same scenario, million dollar property with $100,000 dollars net operating income per year. And the seller is selling that for a million dollars. That’s a 10% cap rate. That’s very good. So so far we’re three out of four. Now the LTV in this case, million dollar property, $800,000 loan, that’s 80% LTV. Hey, satisfied. So it’s four out of four. So that’s pretty good. But let me tell you, this is a illustrative purposes. In reality things are not always this pretty.
So what may happen is that you don’t have the $200,000, so you’re going have to figure out a way to get creative. Some of the ways that the bank says, “I will give you no more than 80%.” So you have to give some seller financing. So you have to figure out is the seller willing to carry a 10% note? So instead of putting $200,000, you only put, in this case, $100,000. So the numbers will change because now you still have the same 80% LTV, but you have more debt, which means it’s going to make your debt service coverage ratio go low. So it’s going to push your debt service coverage ration down. Which if it gets too low, then if you don’t pass this [inaudible 00:10:47] that’s by the lender, you may not have a deal.
So all of this thing is very, very fluid. So that’s what you want to go with somebody who knows what they’re talking about. You want to be able to structure the deal and know that you have all your pieces together long before you go to the lender. So you have to get very, very good at evaluating each property and basically doing your own underwriting to see if it doesn’t make sense to you, why would it make sense to a commercial lender? So this is one example. I’m going to show you another example in just a second.
Okay. Here’s another example. I’ve changed it. I want you to put your underwriting hat on and let’s walk through this together and tell me if you would do this deal. So it’s a one and a half million dollar property. Forget about where it is in the country. It could be anywhere in the U.S. Potential debt service coverage ratio at 1.2. Cash on cash return at 80%. Cap rate or four percent. LTV at five percent. Do we have a deal? Well, not so fast. The 1.2%, if I’m a lender that would make me very nervous because anything can happen and you can actually violate your covenant. One of the things that I do with, because we do have an advisory firm, and we are helping clients with negotiating loan covenants and making sure that every year you may have as a condition of the loan that you have to provide reviewed or compiled or audited financials, whatever it is that you agreed to, you would have to provide.
If I’m getting 1.2, I’ll be fine. But what if you just… All you have to do is fall one point less than that 1.2. It could be 1.19 and you’re in violation. Technically they can recall the loan. That’s something to keep in mind. 80% cash on cash return is still pretty darn good. You take the $60,000 net income operating income divided into $75,000 that you put down, that’s pretty good. Cap rate at four percent. That’s not so good. I mean, I’m in California. So in California, if you go to LA, if you go to the Bay area, you’ll be lucky to get four or five percent. Now for the smaller investor, it doesn’t really make sense. It doesn’t really compute unless you have plenty of cash on hand and you have a million dollars sitting on a CD and you were getting two percent and you want to get four to five percent. Well, that may make sense. It’s a very stable deal, but that doesn’t mean you’re going to have a lot of return on investment.
So the cap rates at four percent means that is probably in a bigger city. And the investor is okay, we’re getting that kind of return. The LTV, now we’re having a problem here. So that means that you only have $75,000 to put down on a million and a half property. So the lender is going to be, “Wait a minute. We can’t do this deal. We can’t do this deal because the numbers don’t pencil out.” If they’re going to front up to 80%, and you only have five percent, there’s a 15% gap. Where’s the money going to come from? So this is where you have to get creative. You have to either have the seller carry the 15% that is required for this deal to be done. But then they may or may not. Depending on the situation of the seller, the seller may be in a distress situation, which means that something happened in their lives that they really want to dump the property, but if a seller is so willing to dump the property, should you be concerned?
So this is kind of what helps you understand really just within 60 seconds of looking at this number, should be able to know whether you should want to look into this farther? Now, if I’m a lender I’m looking at this deal, I say it’s a no. So hopefully that helps you out. Thank you so much for watching my video.
Hey, please comment below and let me know if you run into any of these four criteria when applying for a loan and what you did about it. Also, if you want to join a community of like-minded, successful entrepreneurs just like you, then join our Facebook group at the link below where I share tips, tactics and strategies, and how my clients are growing their businesses to seven figures and beyond.
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