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Real Estate Finance Terms and What They Mean

CV Real Estate Finance Terms And What They Mean 20180217

By Zac Miller, Relationship Manager

For borrowers, investors and originators alike, its extremely important to understand what makes a good loan and the value of its collateral. This can be made much simpler by understanding general real estate finance terms and the concepts that are applied when underwriting a loan.

Additionally, being on the same page regarding these terms can help minimize risk to all parties involved. For example, placing the proper debt to value/cost basis (especially in balloon structures), ensuring monthly coverage of loan payments and understanding how different factors impact those payment amounts are all crucial when arranging financing.

LTC vs LTV

When underwriting the finance or purchase of a commercial real estate loan, a certain “Loan to Cost” (LTC) or “Loan to Value” (LTV) percentage is given as a limiting factor to the proceeds of that loan; however, LTC and LTV are very different and it’s extremely important to understand the distinctions between the two.

LTC is used to finance new properties prior to construction or existing properties prior to rehab (usually distressed or neglected) and is based on the total cost to construct or rehab the project. In addition to the hard construction & rehab costs, lenders will also evaluate the borrower’s credibility and experience, as well as the location and value of the property where the project is being built. LTC is often less than the final Fair Market Value or After Rehab Value, and it’s not uncommon to see lenders offer up to 80%-90% LTC.

LTV is typically used when purchasing or financing an existing structure after construction or rehab is completed. The “value” assigned is usually based on a combination of market sales and rental comps, income from the property, age and condition of the structure, and history and credit worthiness of the tenants, among other factors. Because Fair Market Value or After Rehab Value is usually the highest and best use of a property (and in turn the highest value) lenders will usually cap LTV at 70-80%, slightly lower than LTC.

The most important take away of both metrics, however, is the correlation between risk, rate and percentage of LTC/LTV. The higher the LTC/LTV, the riskier the loan (in theory) and the higher the interest rate. For borrowers, it is extremely important to understand the exact amount of proceeds you need for your business plans, and not over leverage. Not only are you putting yourselves at more risk, you’re paying more to do so! By having more equity in your property, you’re mitigating the risk of a balloon payment exceeding the value (should values decrease). And, by having a lower rate, you’re reducing your monthly payments. In other words, why pay for what you don’t need?!

Debt Service Coverage Ratio

Speaking of monthly payments, Debt Service Coverage Ratio (DSCR) is another important concept to understand to help ensure a performing loan. DSCR is simply the ratio used to compare Debt Service (your loan payments) to the Net Operating Income (NOI) of the collateral. If your Debt Service is $12,000 a year and your NOI is $12,000, your DSCR is said to be 1.00. If your Debt Service is $12,000 a year and your NOI is $14,400, your DSCR is said to be 1.20 ($14,400/$12,000 = 1.20).

Lenders will typically look for a minimum 1.20 or 1.25 DSCR, but just like LTC/LTV that doesn’t mean sponsors should look to fully leverage. The lower the DSCR, the riskier the loan is perceived from the lender’s point of view and the higher the interest rate. From a borrower’s perspective, it may be prudent to try to underwrite your collateral with a higher DSCR to account for variables such as losing a tenant or a major repair to the property. A good rule of thumb is to make sure your NOI without your largest tenant in place still covers your monthly debt service.

Amortization -> Impact on DSCR and monthly payment

Another commonly overlooked component of a loan is the Amortization schedule. To refresh, an amortization schedule is used to break down monthly payments of principal and interest over a set time period, commonly 20, 25 or 30 years. A 30-year amortization schedule breaks down the monthly payments to pay down the full amount over 30 years and a 25-year amortization is paid over 25 years, etc. The goal for borrowers is usually to get the longest amortization as possible. For example, paying down $1MM over 30 years compared to 20 years will leave you with much lower monthly payments, and ultimately, a healthier DSCR.

With a 5 or 10-year term on a 20 to 30-year amortization schedule and a balloon payment, some borrowers ignore the importance of the amortization schedule. This is not in their best interest, as a longer amortization schedule lowers their debt service payments and the risk of default. For example, the monthly payments on a loan at 5.5% with a 30-year amortization schedule is LESS than a loan at 5.00% on a 25-year amortization.

There are many important terms and concepts when underwriting and understanding the financing for your assets, but the aforementioned plays a pivotal role in helping you understand risk, rate and cost. Make sure you understand exactly what you need and be sure to tailor your financing around that to ensure the best pricing and performance.

With a better understanding of the terminology, are you ready to obtain investment financing? We can help! CoreVest is the leading provider of financing solutions to residential real estate investors. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how Corevest can help grow your rental and rehab business, 786.686.2856 or email zac@cvest.com.

 

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