Commercial Real Estate Loan Sizing Explained

Commercial real estate loan sizing is one of the most important concepts to understand when you’re involved in this industry, whether you’re working as an analyst or investing in your own deals.

And while residential loan sizing is usually pretty straightforward and determined by a borrower’s income and the value of a property, commercial real estate loan sizing has a lot more moving pieces.

So break this down in more detail, this post walks through the four main loan constraints that commercial real estate lenders use, and how all of these work together on a deal.

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Understanding Loan Constraints

Throughout this post, I’ll be referring to loan “constraints”, which are the metrics that commercial real estate lenders use to come up with a maximum loan amount on a deal they’re considering funding.

Constraint #1: Loan-to-Value Ratio (LTV)

To start off with arguably the simplest constraint of all four of these metrics, we have the loan-to-value ratio, or LTV.

How LTV Works

The LTV measures the loan amount as a percentage of the value of a property, with value typically being determined by a third-party appraiser, and lenders will set a maximum LTV percentage to size a given loan.

For example, if a lender has a maximum LTV constraint of 65% and a property is valued at $10 million, loan proceeds would max out at $6.5 million, regardless of the interest rate or the income the property generates.

Why LTV Matters

This metric is primarily intended to help lenders protect the value of their collateral (the property securing the loan), specifically if they have to foreclose on an asset and sell the asset to a third party.

Most lenders will have a maximum LTV ratio somewhere between ~60%-75%, but this can vary a lot based on the business plan, the property type, and the type of loan product the borrower is looking for.

Constraint #2: Loan-to-Cost Ratio (LTC)

Next up from here, we have another relatively straightforward loan constraint, and this is the loan-to-cost, or LTC ratio.

How LTC Works

The LTC measures the loan amount as a percentage of the total cost of the project, not just the value of the property at the time loan proceeds are issued. This means that the LTC includes the purchase price of the property and also any closing costs, up-front leasing costs, or planned renovations that will increase the investor’s basis.

For example, if we were to buy that same $10 million property, we planned to put $1 million of additional capital into it, and our closing costs were projected to be another $100,000, our total cost would be $11.1 million. And with a 65% loan-to-cost constraint, our maximum loan amount in this scenario would jump to $7.215 million.

When LTC Is Most Important

Similar to the LTV ratio, maximum LTC values will typically come in anywhere between ~65%-75% of total project costs. The LTC ratio is usually relied on most heavily when the value of the property at the time of acquisition isn’t indicative of what the value is projected to be once the property is stabilized, which is often the case on ground-up development projects and major value-add deals.

Constraint #3: Debt Yield

The next loan sizing constraint that’s commonly used by real estate lenders is directly dependent on the income generated by a property, and this is the debt yield.

How The Debt Yield Works

The debt yield measures a property’s net operating income on an annual basis as a percentage of the total loan amount. This means that if a property were to generate $600,000 of annual net operating income and the loan amount was $6 million, the debt yield in this scenario would be 10%.

Calculating The Maximum Loan Amount Using The Debt Yield

With the debt yield as a loan constraint, lenders will back-solve for a loan amount based on the property’s NOI and the minimum debt yield they’re willing to accept. To do this, they’ll take the property’s annual NOI and divide that by the minimum debt yield to get the maximum loan proceeds they’re willing to issue.

Minimum debt yields are often somewhere between ~8-12%, depending on the business plan, the property type, and the type of loan product the borrower is looking for. With that said, in general terms, lenders are usually looking for reasonable assurance that they’ll be able to maintain their yield in a foreclosure scenario.

Why Debt Yield Matters

Just like equity investors, lenders make investments in commercial property to generate a return on those investments, in the form of interest they charge to the borrower. However, if that borrower defaults and can’t pay those interest payments, the lender may have to foreclose and take ownership of the property.

In these types of scenarios, the lender would still want to make sure to at least be able to generate that original interest on the loan, which is where these debt yield requirements come into play.

With a 10% debt yield and a 6% interest rate, the NOI of the property would need to decrease by over 40% to fall below the interest generated by the lender. And when this is the case, even in a foreclosure scenario, it’s very likely that a lender would still be able to maintain their yield until the property is ultimately sold.

Constraint #4: Debt Service Coverage Ratio (DSCR)

Finally, we have one more loan constraint that’s also dependent on the NOI a property can generate, and this is the debt service coverage ratio, or DSCR.

How DSCR Works

The DSCR is calculated by dividing the property’s annual NOI by the annual debt service owed to the lender, and this measures how many times over a property’s income can cover required loan payments.

Minimum DSCR requirements for lenders usually fall between ~1.2x-1.5x, again depending on the business plan, the property type, and the type of loan product, and this is one of the most heavily relied upon metrics for lenders sizing loans.

Calculating Maximum Loan Amount Using The DSCR

The way lenders will use this metric is also by back-solving for a loan amount that meets their required DSCR figure, factoring in the interest rate and amortization period (that will also affect monthly payments).

For example, if a lender had a 1.35x DSCR constraint using a $600,000 NOI, we could calculate the maximum loan amount by first calculating the maximum annual debt service that can be supported by the property. We do this by dividing $600,000 by 1.35, which equals $444,444.

From there, we can use Excel’s built-in PV function to calculate the loan amount. If we assumed a 6% interest rate and a 30-year amortization period, we could use our interest rate on a monthly basis as our ‘rate’, our amortization period on a monthly basis as our ‘nper’, our maximum debt service on a monthly basis as our ‘pmt’, and 0 as our ‘fv’ to get $6,177,467 in total loan proceeds based on all of these factors.

Putting It All Together: The Minimum Rules

The way a lender will ultimately use each of these loan amounts together is that they’ll take the minimum total figure among all of these constraints.

So in this scenario, we have maximum loan amounts of:

• $6.5 million based on our LTV constraint
• $7.2 million based on our LTC constraint
• $6.0 million based on our debt yield constraint
• $6.2 million based on our DSCR constraint

Our maximum loan amount on the deal would be $6.0 million in this case, even though the DSCR, LTV, and LTC constraints could actually support higher loan amounts on this deal.

How To Master Commercial Real Estate Finance

If you want to learn more about how these metrics factor into a real estate investment analysis, or you want to learn how to build these into a real estate pro forma acquisition or development model, make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.