There are many kinds of real estate investors, both large and small, all with different investment goals. One thing they almost all have in common is that they need to borrow money from a lender. There are many different kinds of lenders: pension plans, insurance companies, savings and loans companies, banks, credit unions, private lenders, and even "lenders of last resort," to name a few. Lenders are interested in making money and have various appetites for risk. The desire for a particular yield, the availability of a secondary market to move the risk to, and the availability and cost of money to the lender will drive the pricing of the money they lend.
For example, I have a friend who is a small lender -- a one-man shop. He borrows money (multiple millions) from his bank at the prime lending rate and then marks it up by 8% to lend it out to people who cannot obtain money from standard banking sources. He secures his risk against his borrowers' real estate in the form of a second trust deed, and knows if his clients default, he will need to buy out the first position to perfect his loan. He is comfortable with this risk and with his ability to use money as inventory, lending the same dollars out more than once in a year. Most of his loans are short-term and he gets a significant lending fee up-front to make the deal happen.
My friend is an example of an unusual lender. The conventional real estate lender is a bank or a mortgage banker who finds money for his clients. These conventional bankers use a series of ratios to decide if the property can be successfully underwritten for a loan. It is these ratios that a real estate investor must take time to understand. The following information is needed to base the ratios on.
|Net rentable square footage||10,000 sqft.|
|Gross income||$210,500 appx.|
|Effective Gross income||$200,000|
|Net operating expenses||$100,000|
|Net operating income (before debt service)||$100,000|
|Balance (money needed to borrow)||$750,000|
|Debt Service (750,000 balance, 8% APR, 360 months)||$65,601.47 per year|
|Cash flow = NOI - Debt Service ($100,000 - $65,601.47)||$34,398.53|
The most popular ratios used by lenders are as follows:
- Loan to Value Ratio
- Interest Carry Ratio
- Debt Service Coverage Ratio
- Break-Even Ratio
- Capitalization Rate
They are calculated as follows:
In general, the higher the debt service coverage the better. On the other hand, the higher the Loan to Value ratio and the higher the Break-Even ratio, the riskier the loan is. Values based on CAP rates increase as the CAP rate decreases.
In addition to these ratios, Lenders also analyze the local economy for the area in which the investment is located in as well as the local vacancy rates, condition of the property, location of the property, and the strength of the property management.
In summary, as you review investments and prepare to purchase property, you can use these ratios to determine if a lender will grant you a loan, and what potential terms and conditions might apply. Bear in mind that banks deal strictly in money; yield is what they are looking for. Pay close attention to prepayment penalties (yield maintenance clauses) as these can make or break your potential exit strategy. Some lenders will negotiate their prepayment penalties. Prior to buying a property and closing a loan, it is your obligation to research the options and decide what is in your best interest. The more flexibility you have, the better you are able to respond to changes in the investment environment.