# Commercial Loans Blog

When a commercial lender underwrites a commercial loan, he will use five financial ratios - (1) the loan-to-value ratio, (2) the debt service coverage ratio, (3) the operating expense ratio, (4) the debt yield ratio, and (5) the debt ratio.  We will discuss these five ratios in more detail below.

1.  Loan-to-Value Ratio

The Loan-to-Value Ratio is the requested loan amount divided by the value of the property.  The value of the commercial property is usually established by an appraisal performed by a Certified General Appraiser or a M.A.I. appraiser.  If, however, the purchase price of the commercial property is lower than the appraised value, almost all commercial lenders will use the lower of the purchase price or appraised value in the loan-to-value ratio calculation.

Below are some typical maximum permissible loan-to-value ratios for commercial loans:

Multifamily - 75% to 80% LTV maximum
Office Buildings, Retail and Industrial Properties - 70% to 75% LTV maximum
Self Storage - 65% to 70% LTV maximum
Hospitality - 60% to 65% LTV maximum

If the capital stack includes both a first mortgage and a second mortgage/mezzanine loan, some lenders will compute a Combined Loan-to-Value Ratio, which obviously uses the sum of the first mortgage and the second mortgage/mezzanine loan in the numerator.

2.  Debt Service Coverage Ratio

When making commercial loans, most commercial lenders insist that the net income generated by the property not only equal the proposed mortgage payment, but actually exceeds the proposed payment by at least 25%.

The Debt Service Coverage Ratio is defined as the Net Operating Income divided by the Debt Service, all multiplied by 100%.  Debt Service is merely a fancy way of saying the annual principal and interest payment on the proposed loan.

Please note that this calculation is performed on an annual basis.  You can actually squeeze out a few extra dollars in the loan amount if the calculation is done on a monthly basis using monthly payments.  Sorry, Charlie.  Nice try.  This calculation has to be performed on an annual basis.

What about taxes and insurance?  Do you add these line items to the annual debt service (loan) payment before calculating the debt service coverage ratio?  No!  The taxes, insurance, and required reserves are already line items in the Pro Forma Operating Statement (projected budget for the next 12 months).  If you then added these costs to the debt service, you would be double-counting these costs.

Here are some typical minimum permissible debt service coverage ratios:

Multifamily - 1.20 to 1.25 debt service coverage ratio minimum
Office Buildings, Retail and Industrial Properties - 1.25 debt service coverage ratio minimum
Self Storage - 1.25 to 1.35 debt service coverage ratio minimum
Hospitality - 1.35 to 1.45 debt service coverage ratio minimum

3.  Operating Expense Ratio

Just about every commercial loan borrower wants to borrow as much money against his commercial property as he can.  In the debt service coverage ratio calculation, the higher the net operating income, the higher the debt service coverage ratio and the more dollars that the commercial lender will lend.  Therefore the borrower will want to show his operating expenses as low as possible, and a lender making commercial loans needs to be on his guard against a borrower supplying fraudulently low operating expense numbers.

Example:

Bad-Bad Leroy Brown owns an apartment building in Chicago, where heating expenses are a major cost.  When the commercial lender underwriting his commercial loan asks for his 2017 actual operating expenses, Bad-Bad Leroy supplies the actual numbers, but he cuts his annual heating cost from \$61,765 to just \$22,098.  Bad, Leroy, bad!  :-)

The Operating Expense Ratio is defined as the Total Operating Expenses divided by the Effective Gross Income of the property, all times 100%.  The Effective Gross Income is the Total Income minus a Reserve for Vacancy and Collection Loss (usually 5% of Total Income).  If the operating expense ratio is too low, it is likely that the borrower is supplying fraudulent expense numbers.

Below are the minimum acceptable operating expense ratios used by most commercial lenders:

Multifamily - 35% to 40% minimum
Office Buildings, Retail and Industrial - Varies based on the leases (NNN versus full service)
Self Storage - 25% to 35% minimum
Hospitality - 45% to 50% minimum

4.  Debt Yield Ratio

The Debt Yield Ratio is a brand new ratio that was developed after the Great Recession in response to the huge losses suffered by CMBS bond buyers in commercial loans.  In the years leading up to the Great Recession, interest rates were falling, which allowed the buyers of major commercial properties to obtain larger and larger commercial loans in terms of the loan-to-value ratio.  As buyers were able to obtain extremely high leverage, they bid up the prices of major commercial properties to sky-high levels.

To make matters worse, conduits - the originators of commercial loans destined for securitization - started making commercial loans that were interest-only for the first two or three years.  This allowed buyers of major commercial properties to reach insane loan-to-value's of 80% to even 83%!  This further drove up the price of major commercial properties.

When the Great Recession hit, major commercial properties fell by as much as 45% and CMBS bond buyers got slaughtered.  As a result, the CMBS market completely dried up.  An entire industry essentially disappeared.

Five years later, in order to convince CMBS bond buyers to return to the market, the Wall Street guys developed the Debt Yield Ratio.  The Debt Yield Ratio is defined as the Net Operating Income divided by the Loan Amount, all times 100%.  This Debt Yield Ratio was not allowed to be less than some number on commercial loans destined for the CMBS market.  When the Debt Yield Ratio was first developed in 2012, that minimum acceptable debt yield ratio was 10.0%.  Since then this number has come down slightly.

Please note that the debt yield ratio has nothing to do with cap rates, interest rates, or even amortization schedules (interest-only versus a 25-year amortization).  It is a cold, heartless ratio, and conduits continue to use it on all CMBS loans.

Please note that (just about) only CMBS lenders (conduits) use the Debt Yield Ratio!

Below are some typical minimum acceptable debt yield ratios:

Multifamily - 8.0% to 9%
Office Buildings, Retail and Industrial - 8.75% to 9.5%
Self Storage - 9.5% to 10%
Hospitality - 10%

5.  Debt Ratio

The Debt Ratio is a residential lending ratio with which you probably battled when you first tried to buy a house.  You will recall that Fannie Mae would not allow your new mortgage payment to exceed 25% of your gross income or, when combined with your other debt obligation payments, exceed 33% (38%?) of your gross income.

Now in real life, 95% of all commercial lenders will NOT look at your personal debt ratios when underwriting a commercial loan.  As long as you have good credit and your net worth is at least as large of your requested commercial loan amount, commercial lenders seldom bother with personal debt ratios.

However, there is a class of commercial lender, known as a Non-Prime Commercial Lender, which may allow a negative cash flow on a commercial loan, as long as your personal debt ratios can handle the negative cash flow.

Conclusion

Commercial lenders typically use the lowest loan amount allowed by these ratios.

Example:

The CMBS lending division of Morgan Stanley is underwriting a \$7 million commercial loan request on an office building in Washington, D.C.  The highest loan-to-value ratio that the CMBS market will permit is 75%, and according to this ratio, the borrower could qualify for \$7.1 million commercial loan.  The maximum loan size permitted by the debt service coverage ratio is \$6.95 million.  The largest permissible loan at a 9% debt yield ratio is \$6.6 million.  The maximum CMBS loan that Morgan Stanley will allow is \$6.6 million - the most conservative result of these three ratios.

You're a commercial real estate broker.  Your best Idaho client owns a commercial property in Louisiana, and he has a \$700,000 balloon payment coming due on it.  He wants you - the guy who handles all of his commercial real estate matters - to find a commercial lender willing to make a commercial loan on this Louisiana strip center.  Basically he wants you to play mortgage broker.

Are you allowed to work as a commercial mortgage broker in Louisiana?  Do you need a Louisiana mortgage broker's license?  Hmmm.

You do a little magic on Google and locate the Louisiana mortgage licensing statutes.  The statute in question reads roughly as follows:  "In order to broker mortgage loans in Louisiana, the broker must have a Louisiana mortgage broker's license."  Well, that settles that.  Dang!  Your good client is gonna be ticked, and you could have used a quick and easy \$7,000 commission - one point on a \$700,000 new commercial loan.

But wait!  If you order now...  On a hunch, you look up the definition of a "mortgage loan" in the Louisiana statutes.  The statute reads roughly as follows, "A mortgage loan is a loan on a one-to-four family dwelling."  In other words, a "mortgage loan" is loan on a house, duplex, triplex, or four-plex.   The property that you are trying to finance is a strip center.  The Louisiana mortgage licensing statute does not apply.  You can broker commercial loans there all day long there without any licensing concerns, even though you reside in Idaho.  Hooray!

This licensing scheme is very common across the United States.  The mortgage loan licensing statutes will require a mortgage broker's license to broker "mortgage loans", but then a "mortgage loan" in that state is defined as a loan on a one-to-four family dwelling.

You may have noticed that I used the word, "scheme", above.  When most people think of the word, "scheme", they think of something evil, like a scheme to defraud or a scheme to embezzle.  In the law, however, scheme means a large-scale systematic plan or arrangement for attaining some particular object or putting a particular idea into effect.  An example would be a clever marketing scheme.

Back to whether most states require a mortgage broker's license to broker commercial loans, the answer is, "No!"  More than forty states have no licensing requirement at all to broker commercial loans.

Many of the remaining states are unlikely to get their panties in a bunch if you broker only the occasional commercial loan in their state.  For example, if the Idaho commercial real estate broker above happened to have another Idaho client who owned a property in Nevada, the State of Nevada is unlikely unloose the hounds of hell on him for brokering one or two loans per year in Nevada, even though Nevada is one of the few states that does require a license to broker commercial loans.  Now if the Idaho commercial real estate broker started sending out fliers to borrowers in Nevada, the State would likely consider the broker to be in violation of the law.

Several paragraphs ago I used the expression, "clever marketing scheme".  I believe that every commercial real estate office (realty sales office) should have a commercial mortgage brokerage desk.  Why?  There is no easier way to meet accredited investors than to be in the commercial mortgage business.  Almost every borrower you meet is accredited.  After all, poor people don't own office buildings and shopping centers.

Just look at my own organization.  Between C-Loans.com, CommercialMortgage.com, and Blackburne & Sons Realty Capital Corporation (private money permanent loans in the Heartland), we meet a half-dozen new accredited investors every day.  We then eventually take many of these private clients and convert them into trust deed investors.  It makes sense.  Just about all wealthy real estate investors have cash set aside in their IRA's pension plans, college savings plans, and personal savings that are ideal for investing in 9% commercial first trust deeds.

As a realty sales broker, you could sell commercial real estate to your own set of accredited commercial mortgage borrowers.  You've gotta start your own commercial mortgage brokerage desk in your office.  It's easy to do.  Start by ordering my famous nine-hour video course, How To Broker Commercial Loans.

Those of you who are not now practicing commercial mortgage brokers, as they say in the cop shows, "We're done here."  But those of you who are mortgage brokers, we need to have a serious conversation.  Please continue on.

Let's suppose you run across a do-able commercial real estate loan request.  Do you try to broker the deal to a bank that you know, or do you enter the deal into C-Loans.com?  The smart answer is that you do both!

First of all, you get prizes if you enter a bona fide commercial loan into C-Loans.com. You get to choose TWO of the following:  (1) Free regional copy of The Blackburne List containing more than 750 commercial lenders; (2) Free Commercial Mortgage Underwriting Manual (sells for \$199); (3) Free commercial mortgage marketing course (the PDF to our \$199 audio course); or (4) Free copy of my commercial mortgage broker fee agreement.  Contact Tom Blackburne at 574-210-6686 after you have submitted your deal to six banks to get your prizes.

You get your choice of two of the above, just for entering that commercial loan into C-Loans.com.  And you can still submit the deal as well to your favorite bank.  Our banks will simply compete against your bank.

"But George, I am afraid that someone will steal my lead if I post it on C-Loans."  Then simply disguise the street address and borrower's name with the words, "To be disclosed later."

We still have not gotten to the most important reason for entering your commercial loan into C-Loans.com.  You might actually close the deal!  Oh my gosh, if you can close two commercial loans using C-Loans, your income will skyrocket because we will let you start buying our commercial leads, even if you are otherwise unqualified.

We sell our commercial leads for only \$1 to \$9 apiece, plus 37.5 bps. when the deal closes.  Its a helluva deal.  The only bad news is that we now require that you have a credit score of at least 700 and a net worth of over \$700,00 in order to buy our leads.  Too many dishonest and/or poor mortgage brokers were not notifying and paying us when they closed our deals.  By the way, our own income skyrocketed within three months of imposing these tougher lead-buying standards.

Les Agisim, a mortgage broker not much different from you, has closed 51 commercial loans for C-Loans.  Jason Bengert has closed more than 40 loans for C-Loans, and so has Rick Gnafakis.  Paul Elis of PMB Capital is another big closer and a member of the Over-40 Closings Club.

Do you know why they are closing so many deals?  They started out as lead buyers, and after 5 closings we listed them on C-Loans as a Proven Broker.  Now they don't even have to pay upfront for leads.  The leads arrive daily in their inboxes.  (Advice:  If given a choice between submitting your commercial loan to a sleepy, salaried banker on C-Loans and one of our Proven Brokers, choose the Proven Broker!  They close deals.)

So I have a harsh truth:  If you have a commercial loan and fail to enter it into C-Loans.com, its like failing to buy a \$1 million lottery ticket when only ten tickets are being sold.  If you could close just two loans using C-Loans, you could start buying leads.  Then, like Sheldon Sontag, you could get listed on C-Loans.  A half-dozen pre-screened commercial leads would appear magically in your email box every day for the next thirty years.  Most people don't realize that we have already been in business for almost forty years, and my two 30+ year-old sons and our executive staff will carry on after I retire.

All of these wonderful things will happen if you simply start entering all of your commercial loans into C-Loans.com.

Ninety percent of all commercial construction loans that are turned down are rejected because the developer lacked sufficient equity in the deal.  In the parlance of commercial real estate finance, he didn't have enough skin in the game.

Need Equity Dollars?

Are you a real estate developer?  Are you trying to build a project right now?  My name is George Blackburne III, and I'm the attorney that owns both C-Loans.com and CommercialMortgage.com.  I also own Blackburne & Sons, the \$50 million hard money commercal mortgage company that I founded almost forty years ago.

If you need help raising equity dollars, I am available for consultation at the rate of \$375 per hour, with a minimum of only \$100.  I consult three times per week at precisely 1:30 p.m. ET on Mondays, Thursdays, and Fridays.  Please call my son, Tom Blackburne, at 574-210-6686 to set up a consultation

Commercial construction loans can be pretty risky.  You have the risk of cost overruns.  About twenty-five years ago I was financing a deal, and the lumber costs soared by 40% in a single week. You have the risk that the workers will go out on strike.  Labor is getting harder and harder to find these days, and I predict that you will see more and more labor slowdowns, as workers demand higher pay.

You also have the political risk that some government employee could put some last minute kibosh on the project.  Think of that poor developer who discovered that he was excavating into an ancient Indian burial ground; or perhaps the City Council increases the parking requirement at the last moment.  Then there is construction risk.  Imagine a crane falling or dropping an expensive beam.

Then you have marketing risk.  Are the condo's that are you are building going to sell at their projected sales prices?  Is your new office space going to lease at your pro forma rents?  Let's face it, a million thing can, and do, go wrong on commercial construction projects.

As a result, banks are demanding a ton of equity in their construction deals.  During the go-go days before the Dot Com Meltdown, banks were making commercial construction loans of 90% loan-to-cost.  Many got slaughtered when commercial real estate collapsed by 45% after the dot-com stocks melted down.

Eight years later, after the commercial real estate market recovered, banks were making commercial construction loans of 80% loan-to-cost.  Then the Subprime Mortgage Crisis struck, and banks once again got slaughtered in commercial construction lending.

In the wake of the Great Recession, banks regulators really clamped down on commercial construction lending.  Loan-to-cost ratios in excess of 70% were strongly discouraged.  Requiring the developer to contribute 30% of the Total Cost of a development project is a deal killer.  Commercial construction has never recovered to pre-crash levels.

The good news is that a few banks - much less than half the banks - are once again making construction loans up to 80% loan-to-cost.  This still requires that the developer contribute a whopping 20% of the total cost of the project.  The good news is that under the JOBS Act, it is much easier to raise equity dollars these days.

Need Equity Dollars?

Are you a real estate developer?  Are you trying to build a project right now?  My name is George Blackburne III, and I'm the attorney that owns both C-Loans.com and CommercialMortgage.com.  I also own Blackburne & Sons, the \$50 million hard money commercal mortgage company that I founded almost forty years ago.

If you need help raising equity dollars, I am available for consultation at the rate of \$375 per hour, with a minimum of only \$100.  I consult three times per week at precisely 1:30 p.m. ET on Mondays, Thursdays, and Fridays.  Please call my son, Tom Blackburne, at 574-210-6686 to set up a consultation

Topics: Construction loan equity

George Smith Partners is a commercial mortgage banking company and life company correspondent that has been in business since the 1940's.  More precisely George Smith and Company was founded way back in the 1940's.  Management bought the company and changed its name slightly in 1992.  The bottom line is that this was already an old-old company when I first founded Blackburne & Sons way back in 1980.

The term, "correspondent", is an often missed term in commercial real estate finance (CREF).  Lots of blowhard mortgage brokers call themselves correspondents of banks, when in truth they are just mortgage brokers with a good working relationship with a few banks.

A correspondent is the exclusive eyes and ears of some commercial lender, almost always a life company, in some region or city.  All loans in the region are routed through this exclusive correspondent.  In other words, if you were to call the life insurance company (called life companies in the lingo of CREF) directly, they would tell you to call Bob Smith of Granite Commercial Lending, their correspondent for, say, Portland, Oregon.

The most important feature about a correspondent is that a correspondent services the commercial loans that it originates for Whatever Life Insurance Company.  Therefore, I'm sorry, but unless you are servicing the loans for some commercial lender, you are not a correspondent.

Every two weeks I receive a wonderful newsletter from George Smith Partners called, FinFacts.  In this newsletter, the company provides details about recent loan closings.  These closings announcements are also called tombstones, and tombstones are an excellent way to market for commercial loans.

In this week's FinFacts, George Smith uses a number of terms of art (the language of practitioners of commercial real estate finance) that you should know.  For example, in the tombstone of some bridge loan closing, describes the prepayment penalty as follows: "2% for two years and then open thereafter."  Open obviously means free of a prepayment penalty.

The commercial loan was "priced at L + 300".  The "L" stands for LIBOR, the London Interbank Offer Rate.  It is the rate at which European banks lend reserves to each other, and it is roughly comparable to our Federal Funds Rate.  Most commercial loans tied to LIBOR use either the three-month or six-month LIBOR rate.

FinFacts talks a lot about commercial loans being sized.  Sized means the maximum loan amount that the lender would lend, and it is usually the lower of the maximum loan size allowed by the loan-to-value ratio and the maximum loan size allowed by debt service coverage ratio.  If the lender is  a conduit, the lender may also use the debt yield ratio.  The debt yield ratio typically produces the smallest loan size.  In other words, its the toughest ratio to get past.

Many commercial lenders on their commercial loans will insist on a holdback for TI's and LC's.  TI's stand for tenant improvements, which is an allowance given to new tenants to fix up the space to their liking (carpets, walls, bathroom rooms, etc.).

LC's are leasing commissions.  When a sponsor builds or renovates a commercial building, he will usually have to hire a leasing agent to find a tenant for the space.  The leasing commission can be substantial, so it needs to be built into the budget.

The landlord budgets a 4% to 6% commission for the listing agent, which is split with the tenant broker upon completion of the lease.  The split is most often 50/50, but can be as low as 90/10 in favor of the listing agent.

Topics: commercial loan terms