3 Lending Ratios You Should Know

Commercial lenders follow very specific guidelines when approving loans for commercial real estate projects. Commercial real estate loans involve substantially greater risk than regular loans because of the large deal sizes that can range from thousands to millions of dollars per project. As a result, commercial lenders employ three major ratios into order to ensure that they are repaid. Understanding these ratios can be extremely advantageous to borrowers in that they can better present their case to potential lenders and increase their likelihood of funding.

Loan to Value (LTV)
The Loan to Value is the most popular ratio in real estate. LTV is calculated by adding the total amount of the outstanding loan balance (all mortgages) and then dividing that number by the estimated property value (or market value), which is determined by an appraiser. In commercial real estate, this ratio is typically capped at around 80% in a normal market and even less in a tight market. The remainder of the amount must be covered by the borrower and serves as a buffer for the lender against borrower default.

Debt Ratio
The debt ratio is the second most popular ratio that lenders use during the underwriting process. The debt ratio compares the amount of personal monthly debt that the borrower must pay each month to the amount of monthly income that he or she earns. The ratio can be calculated by dividing the monthly debt obligations by the monthly income. Typically, commercial lenders prefer to have debt ratios below 40%. It is worth noting, however, that commercial lenders rarely look at the borrower’s personal debt to income ratio (DTI) and instead focus on the property’s income and expenses. In the end, the income from the property should more than cover the debt service.

Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio (DSCR) is the third most popular ratio used by commercial lenders. This ratio is more sophisticated and predominantly used for larger loans on income producing properties, such as office building or apartment buildings. The ratio is calculated by dividing the total net operating income by the debt service. The DSCR is set by the property type and the amount of risk that each lender prefers to take. Apartment properties are considered to be the least risky while office buildings are much more risky due to the ease of movement by tenants. The exact figures are often determined based on monthly figures not annual figures. And in general, the number is typically required to exceed 1.0 and may be required to be around 1.2x or 1.3x.

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