Commercial mortgage lending 101: Preparing a cash flow pro-forma to approve a loan - by Stephen Sobin

Stephen Sobin, Select Commercial Funding

How do commercial mortgage loan underwriters determine if they are able to approve a commercial mortgage request? What calculations do underwriters perform when evaluating a loan scenario? Banks and other conventional lenders (as opposed to hard money lenders or bridge lenders) are concerned about an investment property’s ability to generate cash flow and generate positive returns on investment. They will prepare a cash flow pro-forma for all loan submissions.

The following is a pro-forma for a hypothetical apartment building with 25 rental units. The average rental is $750 per month:

• Potential gross income: $18,750/month or $225,000/year

• Less - Vacancy allowance (say 5%): $11,250

• Effective gross income: $213,750

Less - Expenses

• Management (say 5%): $10,688

• Real estate taxes: $35,000

• Insurance (estimated at $300 per unit per year): $7,500

• Repairs and Maintenance (estimated at $750 per unit): $18,750

• Utilities: $40,000

• Misc. (estimated at 2%): $4,275

Net Income: $97,537/year

We’ve now arrived at a net operating income or NOI of $97,537 per year. An investor who purchases this property will earn an annual return on his investment of $97,537. Let’s assume that the expected Cap Rate in this market is 6%. We can determine the value of this property by dividing the NOI by the cap rate. In this case, $97,537 divided by 0.06 equals $1,625,617. Cap rates will vary by neighborhood, property condition and property type.

Next, an underwriter will calculate the Debt Service Coverage Ratio (DSCR). The DSCR is defined as the NOI divided by the annual mortgage payments (called Debt Service). Notice that in the example above we did not list mortgage payments as expenses. How much of a mortgage can this property support? A typical lender will look for a DSCR of 1.25 or better. Said differently, the NOI needs to be at least 25% greater than the payments. Continuing our example:

We have determined that this property has an NOI of $97,537 per year. Dividing by 1.25 gives us the maximum annual debt service of $78,030 or $6,502 per month. This means that our proposed mortgage payment must not be greater than $6,502 per month. If we use an interest rate of 4.25% and a 30-year amortization, we come up with a maximum loan amount of $1,321,706 as the maximum loan amount an underwriter will consider using the DSCR method.

Lastly, the underwriter will consider the proposed loan to value ratio or LTV. Most investors are already familiar with the LTV ratio: it is defined as the loan amount divided by the property’s value. Most commercial mortgage lenders will lend up to 75% LTV. Continuing our analysis, if the property appraises at $1,625,617, a 75% LTV will yield a maximum loan of $1,219,213. In most cases the maximum loan calculated by the DSCR method will differ from the maximum loan amount as calculated by the LTV method. The lower number will always be used, and in this case, the maximum loan amount will be as determined by the LTV method at $1,219,213 versus the $1,321,706 as calculated by the DSCR method.

As this pro-forma shows, there is no guesswork when it comes to approving commercial mortgage loans. Underwriters employ very specific formulas to determine net operating income, cash flow, debt service coverage ratios and loan to value ratios. Borrowers who understand these calculations and are able to present an accurate loan summary to a commercial mortgage lender stand the best chance of having their commercial mortgage loan approved. When you present your loan application to a lender, make sure you have calculated a proper NOI, LTV ratio, and DSC ratio. Also make sure you are well acquainted with the cap rates for that property type and location. Underwriters will appreciate your efforts.

Stephen Sobin is the president and founder of Select Commercial Funding LLC, Atlantic Beach, N.Y.