Lenders, like other business people, have as their primary directive the intention of making money. A lenders process for doing so is by renting money.

In order to assist themselves in this process, that is in lending their money, collecting rent and having their original investment returned to them, they have developed formulas and guidelines upon which they rely. As in every arena, once a person understands the mindset of the participants and the rules by which they play, survival in their game becomes a much more likely and profitable experience. Specifically, investors who understand a lenders objectives and parameters greatly increase their odds of investment success.

The theory is this: a lender wants to make sure that the investor who comes to them seeking a loan on an investment property will have the capacity to pay them their required profit and then return their capital. They want both the return "of their investment as well as the return "on" their investment.

They figure that if the cash flow generated by the investment is great enough to: first, cover the total monthly expenses, second, to retire their debt and third, leave enough cash to cover any contingencies the odds of getting repaid is very high. One formula used by Lenders to determine the maximum loan that they can safely make on an investment or commercial property is the Debt Coverage Ratio (DCR).

The formula for the DCR calculation is: Net Operating Income (NOI) / Annual Debt Service = Debt Coverage Ratio. The process of arriving at the ratio is:

Gross Scheduled Income
Less: Vacancy
Less: Credit Loss
Equals: Gross Operating Inc. (GOI)
Less: Expenses (Operating)
Equals: Net Operating Income (NOI)
Less: Debt Service (DS)
Equals: Cash Flow Before Tax (CFBT)
Less: Taxes
Equals: Cash Flow After Tax (CFAT)

Today the DCR on most multi-family investments is approximately 1.20. (It is sometimes correctly quoted as 1:20 to 1.) Under I these guidelines, if an investor wished to acquire a ten unit building, the average rent for which was $800 per unit, and it had a 5% annual vacancy and 28% expenses, the numbers would look like the following:

So, the amount of money available to retire the debt (make the mortgage payments) on the property, the NOI, is $65,665. If we divide the NOI by 1.20 the result is $54,720 that is available annually to make payments and still leave some cash flow. Of course, while this CFBT represents a cash return to the investor, it means to the lender that there are funds to pay for contingencies that may arise and still not jeopardize their loan. (Just as one man's ceiling is another man's floor, one man's cash is another man's cushion.)

When we divide $54,720 by 12 we determine that the money available for monthly payments is $4,560. Therefore, on a loan amortized over 25 years at 9% interest, the maximum loan amount that a lender requiring a 1.2 DCR will make is $543,000.

If another of the lender's requirements is that they will not loan in excess of 80% of the property's market value (a common criteria called the Loan to Value ratio [LTV]), then the maximum loan on this building ($543,000) would dictate a value for the property of $678,750 - from the lender's point of view. Interestingly, in this example, this would make the cap rate (NOI / Value = Cap Rate) 9.67%, a fairly high cap rate in today's investment world in Boulder County.

Obviously, if the lender's requirements for their DCR were only 1.10, as it sometimes is, then the amount they would be willing to loan would increase to $592,500 ($65,664 / 1.10 = $59,645 / 12 = $4,975 available for monthly payments. These payments will amortize a 9% interest loan of $592,500 in 25 years.) Again, using the 80% rule for the maximum LTV, this lender would loan $592,500 on a building with a value of not less than $740,625. This is a cap rate of 8.87%.

Why would a lender change his DCR requirements? One reason is supply and demand. As a lender finds himself with more money to loan and fewer quality projects in which to invest his funds, he varies his criteria to meet changing market conditions. Another reason is security. As a lender's risk changes he comes under pressure to alter his lending criteria. Another answer is profit. As a lender's perceived profit increases or decreases, from whatever cause, the greater his motivation to modify is his lending criteria.

Lenders constantly seek good, solid investment opportunities that have low risk and high profitability. Recognize these motivations? Sound like anyone you know? The closer you can synchronize your objectives with your lender's the more successful - and the more profitable -will be your loan negotiations.

One more word for sellers. It is a given that your NOI is the critical factor, under your control, in maximizing the amount of loan a buyer will be able to get on your building. It is also a given that the more money a buyer can borrow to acquire your property the greater price he will be willing to pay.

In other articles I have pointed out the value of having your NOI as high as possible. This is but another example. To make the DCR work in your favor, maximize your NOI. - MH