How Lenders Evaluate Real Estate Deals

If you’re investing in commercial real estate, understanding how lenders look at deals is extremely important, and there are a few key metrics you need to know if you’re getting into this business.

These metrics impact the loan proceeds a lender is willing to issue, how much cash an investor will be able to put in their pocket each month, and how much risk both the borrower and the lender are ultimately taking on.

So in this post, we’ll highlight what these metrics are, how each of these is calculated, and how these can impact a commercial real estate deal.

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Metric #1: Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio is calculated by taking the net operating income of a property and dividing this by the annual debt service owed by the borrower, and this essentially measures how many times over the property’s income can cover the borrower’s required loan payments.

And what makes this figure so important to lenders is that this provides a really clear indication of how much cushion a property has to continue making loan payments if the NOI of the property were to decrease in the future.

For example, if we were acquiring a property that generated $1 million in annual net operating income, and annual debt service on the loan was $800,000, the DSCR on this property would be 1.25x. This also means that the NOI of this property could drop by 20% before investors would need to come out of pocket to service the debt.

Lenders will typically set a minimum DSCR figure, which can vary based on the property type and the general risk profile of the deal, but in most cases, this will come in somewhere between about 1.2x and 1.5x.

This means that a lender will back-solve for a loan amount that would result in annual loan payments that produce their target DSCR, so for a property with $1 million in annual net operating income, with a 5% interest rate, a 25-year amortization period, and a minimum DSCR of 1.5x, loan proceeds would max out at just over $9.5 million.

Because higher debt service coverage ratios typically reduce a lender’s risk, these will also often come along with more attractive loan terms overall, like extended interest-only periods, prepayment flexibility, and in some cases, even a lower interest rate.

Metric #2: Loan Constant

The loan constant is calculated by dividing the total annual debt service by the total loan amount, and this measures the borrower’s annual loan payments as a percentage of total proceeds.

And because of the principal portion included within each loan payment, the loan constant will actually be higher than the interest rate that’s quoted on a deal, and in some cases significantly higher depending on loan terms.

For example, if a borrower were to take out a $5 million loan at a 5% interest rate, amortizing over 30 years, the annual debt service on that loan would be $322,093, which would make the loan constant 6.4%, or 140 basis points above that interest rate.

But if a borrower were to take out that same $5 million loan, this time at a 3% interest rate, amortizing over 25 years, the annual debt service would drop to just $284,527, but the loan constant would decrease to just 5.7%, which is a 270 basis point jump above that interest rate.

Positive vs. Negative Leverage

This is why, in some cases, investors will actually see a lower cash-on-cash return with debt than without it (even if their interest rate is relatively low), and this is what’s referred to as negative leverage.

If the cap rate (or the NOI divided by the property value) is lower than the loan constant, this indicates that a deal has negative leverage, where the cash-on-cash return is lower with debt than without it. In a positive leverage scenario, the opposite is true, where cash-on-cash returns will be higher with debt than without it.

For example, if an investor were to buy a property for $20 million at a 6.0% cap rate in an all-cash transaction, that cash-on-cash return in the first year of ownership would also come in at 6.0%.

But if that investor were to finance this acquisition with a $15 million loan at an even lower 5% interest rate, amortizing over 25 years, the loan constant on the debt would come in at 7.0%, and the cash-on-cash return in that first year of ownership would drop to just 3.0% for the investor.

In general, the shorter the amortization period and the lower the interest rate, the higher the spread between the interest rate and the loan constant is going to be, and vice versa.

Metric #3: Debt Yield

The debt yield is calculated by dividing the net operating income of a property by the loan amount, and this measures the NOI generated as a percentage of the capital the lender has contributed.

If a lender has to foreclose on a property, that NOI becomes the income they can expect to generate on the investment, which makes this one of many ways a lender ensures they can maintain their yield in a downside scenario.

In most cases, the NOI would also drop substantially from the starting NOI when loan proceeds were initially issued, which means that for a lender to replace the yield they would have earned if they had to take back the asset, the required debt yield on a loan will typically be significantly higher than the interest rate that’s quoted.

Minimum debt yields are typically somewhere between about 8.0 and 12.0%, again depending on the property type and risk profile of the deal. And when using the debt yield as a loan constraint, lenders will divide the property’s NOI by their target debt yield percentage to come up with the maximum loan proceeds they’re willing to issue.

Metric #4: Loan-to-Value (LTV)

The loan-to-value (or LTV) ratio measures the loan amount divided by the appraised value of a property, which tells a lender how much the property value could fall before the borrower ends up under water.

For example, on a property valued at $20 million, a $15 million loan would represent a 75% loan-to-value ratio. This means that the property’s value could drop by 25% before the borrower couldn’t pay off the outstanding loan balance when selling that property to a third party.

Metric #5: Loan-to-Cost (LTC)

The loan-to-cost (or LTC) ratio is very similar to the LTV, but instead of dividing the loan amount by the appraised value of the property, this metric divides the loan amount by the total cost of the project. This total cost figure typically includes the purchase price, closing costs, and any planned construction costs that are intended to improve the property.

This tends to be the most relevant metric for ground-up development projects and major value-add deals, where the value of the property at acquisition isn’t necessarily indicative of what the value of the property will be in the very near future.

For most lenders, maximum LTV and LTC ratios will typically come in somewhere between about 60-75%, but this can also vary based on the details of each deal.

How To Learn More About Real Estate Debt

If you want to learn more about how these and other loan terms and metrics play into a real estate investment analysis, 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.