The exact answer to what your loan amount will be usually is not determined until the lender issues a final loan commitment. Multiple variables can impact the loan amount during the due diligence process.
Variables Impacting Loan Amount
At a property level, positive or negative fluctuations in cash flow may have a relative impact on proceeds.
At a market level, fluctuation in interest rates will drive proceeds up or down. Most permanent lenders in the investment real estate space do not lock in the rate until shortly before closing. The best case is when they honor the rate range from the time of application. Even in that scenario, however, other property-level variables will reduce your loan amount.
In some scenarios, it makes sense to purchase an Early Rate Lock (ERL). This usually makes sense only on larger, institutional-sized transactions. The appraiser’s final budgeted expense figures will be a huge driver in the underwritten income. How they view your reassessed taxes and budgeted variable expenses will sway your loan amount as well.
Approaches for Determining Loan Amount
The property-level and market-level variables impacting your loan amount are centered around one of the two core approaches lenders will use to determine your loan amount. You will find that lenders use the lesser of either a leverage-constrained approach or a proceeds-driven approach to determine your proceeds.
Leverage-constrained method. This is the most commonly used approach to determine your loan amount. This is the maximum loan to value a lender will allow. This approach has historically been acceptable due to the low interest rate environment and reasonable pricing that allows a property to service the proposed debt at or above the minimum required Debt Service Coverage Ratio (DSCR).
Industry standard leverage is 75% to 80% loan to value in the multifamily space. In the past, meeting or exceeding the minimum DSCR requirements has not been an issue. In fact, in many cases, some property improvement funds have been able to be included in the permanent loan due to excess cash flow.
Although a maximum leverage of 80% has come to be expected, there are certain scenarios where maximum leverage is reduced. Fannie Mae has outlined specific markets where their lenders only have delegated authority to fund up to 65% LTV. These are referred to as pre-review markets because if that lender wants to fund a loan amount above 65% LTV, they need to send the request in to Fannie Mae to “pre-review the deal, with the expectation of receiving a waiver for higher leverage.
Inside of this guideline there are levels, or tiers, of pre-review restrictions. In a Tier 3 pre-review market, lenders are delegated up to 65% LTV. In a Tier 4 Pre-review market, Fannie Mae lenders are delegated up to 55%. Waivers in Tier 4 pre-review markets are not likely; however, solid deals have a healthy chance of receiving the requested waiver in Tier 3 markets.
This re-review designation is typically the result of a market presenting limited and/or dominant economic drivers (i.e., military, oil and gas, etc.). You will also find that max leverage is often reduced to 75% in smaller markets. Even if multiple industries are represented, limited population and market size is a concern.
As mentioned, in a buyers’ market where cap rates are higher, debt service is typically not an issue. This leverage-constrained approach is used to define the loan amount, meaning leverage was capped or “constrained” by the maximum LTV allowable by the lender.
As cap rates compress and interest rates rise, the underwritten net operating income will not support the same leverage as it once could. Both cap rate and debt service coverage ratio utilize NOI as a constant. So, if the NOI remains the same, and the DSCR stays the same, the resulting loan amount will, of course, stay the same. Using this same NOI figure, a compressed cap rate will increase the purchase price, resulting in lower LTV. An increased rate environment exacerbates the proceeds issue in that the NOI will support a lower loan amount, further reducing the LTV.
Proceeds-driven method. In the current market, it is common to underwrite deals using a leverage-constrained approach only to find that the cash flow from the property will not support the request. The anticipated LTV is a staple of any underwriting template, but you should also run the necessary calculations to confirm current income will support the anticipated loan amount. This is the proceeds-driven approach mentioned earlier.
This approach determines the maximum loan amount the in-place cash flow will support, given a lender’s underwriting criteria. An industry standard underwriting approach is to annualize the trailing three (T3) months of rental collections and add the trailing 12 months of other income to determine the underwritten total income figure. Always remember to use a minimum of 5% vacancy loss, even if the historical vacancy is less. You may be able to reduce that to 3% vacancy in some top markets, but make sure to clear that with your lender before moving forward with that assumption.
Most lenders will consider your budgeted expenses, including a reassessed property tax estimate when determining the underwritten NOI. Note that budgeted expenses will need to make sense and fall in general alignment with both the appraiser’s budgeted expenses and the historical expenses. If a line item is way out of proportion with historical expenses, a logical explanation as to the operational plan is needed to support the change.
This approach depends on underwriting assumptions and brings with it a greater chance of changing during processing. This is not a function of the lender intentionally “retrading” your loan; it’s more a function of cash flow variables changing during processing. Given the typical 60-day closing timeline. The T3 income often fluctuates and, since it is annualized, a minor change in collections can have a material impact on proceeds. On the expense side, the final insurance quote is another line item that can greatly reduce proceeds. It is crucial to communicate with your insurance broker as early as you can to determine where the annual premium will land.
You should also connect with your broker or lender to confirm the debt service coverage ratio typically used in your target market. In top markets like Boston, New York, and San Francisco, lenders often use a DSCR of 1.20. In standard markets like Dallas and Phoenix, you can expect a 1.25 DSCR. This is a typical DSCR on a national level. Lenders may increase the DSCR requirements in smaller markets and lower leverage loans.
Note that this applies to underwriting a permanent loan and is a representation of the health of the current property operations. When borrowers are unable to secure adequate proceeds, bridge debt has been a common solution to achieve the desired leverage. It is important to guard against overleveraging when placing bridge debt on an asset that presents stabilized operations. Always make sure there is adequate forced appreciation to increase value in the short term and facilitate your exit strategy. Additionally, the bridge debt options bring more risk considerations such as refinance risk, and they may reduce your investor distributions in the first few years.
If find your expected proceeds are reduced from maximum leverage, you may decide to increase your equity injection or pivot to a bridge loan—whichever option best aligns with your investment strategy. In either case, the goal is to know your options as early as possible to avoid surprises once under contract and, ultimately, to avoid the major re-trade.
To avoid last-minute surprises and build credibility with lenders and investors, stay connected with Atlantic Investment Capital at www.Atlanticic.com to discuss your investment strategy and dial in the most attractive loan terms to maximize your returns.
Eric Stewart is the owner of Atlantic Investment Capital, Inc., a full-service commercial lending advisory and brokerage firm. Stewart has been structuring finance solutions for both commercial real estate investors and business owners since 1996, with products ranging from equipment leases to commercial real estate loans as well as assumption representation and consulting.
Atlantic specializes in structuring finance solutions for investment opportunities in commercial real estate nationwide. The company leverages direct relationships with both agency and conduit lenders for permanent loans as well as hedge funds and insurance companies for interim financing. Atlantic also provides equity funding solutions for select properties within the domestic United States.
Stewart also provides an advisory platform for commercial real estate investors. It is based on more than two decades of working with clients who are dealing with the challenges of financing commercial real estate acquisitions.