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Don Romano Certified Mortgage Consultant MNLS ID: 4023 |
Sample Small Commercial Purchase
In order to understand how an investor or a lender does an analysis on a commercial property we are going to need to define the terminology that is used. Adjusted Gross Income (AGI): This is the annual gross rent of the property less a factor to reflect the cost of collection as well as vacancies. No property is rented 100% of the time and there are times that legal action needs to be brought against a tenant. This factor will vary depending on the property type, location and tenant make up. Replacement Cost Reserves: In addition to normal repairs on a property there will a cost for major capital improvements. Every component of the property has a useful lifespan. Funds need to be budgeted for this each year. This way when the elevators or the boiler need to be replaced the funds will be available. Debt Service: Debt service is the annual principal and interest payment (P&I) on the subject property mortgage. Mortgage payments are always quoted on a monthly basis; the property analysis is done on an annual basis. (Debt Service = P&I X 12). A lender does the analysis strictly based on cash flow. So a borrower using a 15-year amortization schedule will be able to finance a smaller mortgage than a borrower using a 30-year amortization. Net Operating Income (NOI): The annualized income left after deducting expenses from the gross or potential gross income generated by a property. (NOI = Adjusted Gross Income – Expenses) Debt Service Coverage Ratio (DSCR): DSCR is a measurement of the cash flow of a property. The NOI tells you how much money is left after rents are collected and expenses addressed. From this figure debt service is paid yielding the profit to the investor. The DSCR shows “how close the deal is”. This is a typical presentation from a current owner: Monthly Income: Total $10,000.00 / month Annual Income: $120,000.00
Annual Expenses: Taxes 5,000.00 Insurance $2,000.00 Maintenance 2,400.00 Utilities 2,100.00 Total Expenses: $11,500.00
Net Operating Income: $108,500.00
This is how a lender will analyze the same purchase:
So you can see that the amount of cash available for debt service is substantially less when a more thorough analysis of the expenses is done. The next step is to see how large a mortgage this property can support. No lender is going to allow you to use the entire NOI to cover debt service. They want you to show a positive cash flow after mortgage payments are made. This is done for two reasons. First, you have a cushion at the end of the year to absorb any unexpected expenses through the year. Second, it affords another comfort level to the lender. A property that gives you income every year keeps you interested in maintaining that income. By you protecting your income flow you are also protecting the bank’s cash flow. That’s what lender wants, a dependable return on their investment. Going back to our example. Let’s say our lender wants a Debt Service Coverage Ratio of 1.25. That would mean that they would only allow $72,400.00 ($90,500 / 1.25) for annual mortgage payments. It doesn’t matter which mortgage product is used the mortgage payment would need to be $6,033.33 ($72,400 / 12) or less. A 7% interest only mortgage would support a mortgage of $1,034,000.00 but a 15-year self-amortizing mortgage at 6% will support only a $715,000.00 mortgage. An investment is analyzed based on weighing the size of the perceived profit against the potential loss. From the investor’s prospective he sees the profit potential due to appreciation, increasing in rental income and reduced operating expenses. If he’s successful he will benefit on all three positions. His exposure to loss is that if the project doesn’t develop as planned his initial investment is at risk and if all goes bad he walks from the project and the lender takes a non-performing asset in foreclosure. From the lender’s prospective if all goes well, it gets a predetermined rate of return on its investment, the yield of the mortgage. By agreement, it has no participation in any additional upside potential. It does, however, have a large exposure if the property is mismanaged or the local economy turns bad. Simply put, the investor keeps all the upside rewards that go with the purchase and the lender is exposed to all the downside risk of the purchase. This explains why lenders are conservative in the analysis.
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copyright © 2009, 2012 This page was last updated on 2/17/2012 |