Apartment and Commercial Loans: How big of a loan can I get?

Borrowers often ask the question: "What is the maximum LTV (loan-to-value) you can get for me on this [income-producing] property?" This is a valid and important question in the world of real estate finance, but an honest answer cannot be given to the borrower without more information.

The maximum loan-to-value that lenders are willing to lend is usually based to a significant degree on property type. Apartment complexes, for example, are viewed as relatively safe investments and can usually support higher LTVs - perhaps 75 percent - on a single loan. Land, on the other hand, usually supports an LTV of only 50 percent.

Pretty simple, eh? Well, the property type is only half of the story. The second requirement for income- producing property - that it's income service the debt - is a little more complicated. Most lenders like to see that the "income-producing" property indeed produces income and does so in a way that can cover the expenses, as well as the suggested loan, and then some.

To establish if this is the case, the finance industry uses a little math - so you might want to keep your calculator at the ready. Let's take as a case study the purchase of an apartment complex of 10 units. It is bringing in an average rent of $1,000 per unit per month and has expenses of $3,500 per month. From this, we could calculate the gross and net operating income (NOI) as follows:

$1,000*10=$10,000 gross income per month or $120,000 gross income per year

$3,500*12=$42,000 expenses per year.

Subtracting the expenses from the gross income yields an NOI of $78,000 per year.  With the NOI calculated we are halfway finished. This is where the DSCR - the Debt Service Coverage Ratio - comes in. The DSCR is sometimes referred to by other names: Debt Service Ratio (DSR), and Debt Coverage Ratio (DCR).  However, all these terms mean the same thing:  the ratio of the NOI to the suggested loan payments (principal and interest). Many lenders use a DSCR of 1.2 for income-producing properties. This suggests that the NOI has to be 20% more than the carrying cost of the loan. Returning to our apartment complex example, our $78,000 yearly NOI is $6,500 per month. Dividing this by 1.2, we have about $5,417 per month for principal and interest payments. If we assume a loan amortized over 25 years with a 6 percent interest rate, and use the “time value of money" function on the calculator, we discover that this monthly payment can cover an $840,000 loan. This represents the maximum sum that many conventional lenders would likely be willing to loan on a property such as this based on the property's income.

Given the above, the question still remains: what is the maximum amount that will be loaned on this property? The effective maximum loan amount is the lower of the result of the DSCR calculation above and the maximum LTV on the property type.

This is where the mortgage broker or lender can ask the question, if he or she has not already done so: "What is the purchase price of this apartment building?" If the answer is $1 million, most lenders would be willing to finance 75 percent of that amount or $750,000, since it is less than the $840,000 that the property can carry. Our buyer would need to come up with the difference between the $1 million purchase price and the $750,000 loan amount - $250,000 - plus closing costs.

If instead the purchase price was $1.5 million, lenders would likely be willing to put up the full $840,000 - the amount the property can support. This is because this price represents a loan-to-value of 56 percent - well below the desired maximum LTV of 75 percent for apartment buildings. This would require the buyer to come up with the difference between the $1.5 million purchase price and the $840,000 loan amount - $660,000 - plus closing costs.

There is some flexibility in the above. Although the DSCRs often hover around 1.2 for most lenders, some lenders use somewhat lower DSCRs, allowing the borrowing of more money, and some do the reverse and lend less. For example, there is at lease one lender that uses a 0.8 DSCR in some cases. Also, some lenders might allow more flexibility in projected versus current rents. Some lenders are more or less lenient on the amount that should be allocated for expenses for example, 3 percent versus 5 percent for the management fee. Also, the program and rate that the borrower and property might qualify for could be different, resulting in a lower qualifying rate or interest only payments that would support a higher loan amount. Lastly, there are other financing sources that might allow the effective loan amount and LTV to go higher than otherwise possible, such as seller financing, mezzanine financing and joint ventures (usually for larger deals).

In summary, if a borrower looking for financing for an income-producing property wants to know what the maximum LTV on a conventional buy-and-hold loan would be, he or she should expect this to be based largely on the ability of the property to carry it. Consequently, borrowers should not be surprised when they hear a broker or lender ask, "What is the net operating income?" in response to their initial question, "What is the maximum LTV you can get for me on this property?"