For commercial real estate loans, the income-generating capacity of the property to support the loan must be carefully analyzed and fully understand. The underwriting of CRE loans traditionally considers net operating income, debt-service coverage, and loan-to-value:
- Net operating income (NOI) – The overall performance of a firm’s operations before considering nonoperating revenue and expenses, extraordinary items, and income taxes, it equaling gross potential income (GPI);
- Debt-service coverage ratio (DSCR) – A ratio of net operating income to annual debt service, including insurance and maintenance, which indicates the ability of a property or a tenant to service its debt;
- Loan-to-value (LTV) – The maximum loan amount a lender is prepared to advance as a percentage of the value of the eligible collateral, it being the ratio of the loan amount divided by the market value of the property and other collateral securing the loan.
For income-producing properties, NOI equals the total rent from the property if it were 100% leased at market rates plus ancillary income less vacancy and collection loss and operating expenses, excluding debt service, depreciation charges, and income taxes.
LTV generally depends on the nature of the borrower (individual or business), the type of real estate serving as collateral (residential or commercial), and the property. The appropriate LTV considers the particular risks presented by each loan and property type.
The loan-to-value for a commercial mortgage can be 50% to 80%. LTV ratios for a new business with no trading history might be a maximum of 50% of the purchase price of the property, while owner-occupied businesses, such as offices or shops, with a trading history may have an LTV of up to 80%.
Loans for property development or other higher-risk properties call for relatively low LTVs and more equity. Loans that are secured by stabilized property having little volatility in cash flow and value get higher LTVs.
