Commercial Mortgage Term Defnitions

NET OPERATING INCOME "NOI" - By subtracting normal "project" expenses from normal "project" income, you arrive at NOI. Be sure that you do not include in the normal expenses the following: (1) interest and principal on the existing loan we are going to pay off, (2) major capital improvements like replacement of roof, new parking lot, major renovations, etc. (3) expenses from another project. Most lenders will want to see this in a spreadsheet format (one column for each year) the income, expense and NOI for the past 3 years and budget for this year and the next two more years. They may also want to see the income, expense and NOI for the latest "rolling 12 months", which is the 12 months preceding your application.

DEBT COVERAGE RATIO "DCR" or "DSC" - Most lenders will require a particular DCR (also called Debt Service Coverage) for each type of property. This is normally expressed as a ratio like 1.25:1.00 meaning 1.25 to 1.00. The first number (1.25) means the NOI and the next number (1.00) means the Annual Debt Service on the proposed loan. The Annual Debt Service is the total of the principal and interest payments for one year on the proposed loan. For example: the annual debt service for a $1,000,000 loan amount at 10.00% interest rate with 30 year amortization is $105,308. If the required DCR is 1.25:1 and if the annual debt service is $105,308, then the NOI would need to be at least 1.25 times greater than the annual debt service. In this example the required NOI would be $105,308 times 1.25, or $131,635.

PROJECT LOAN AMOUNT - The loan amount of the property "Project Loan Amount" is determined by the NOI and the DCR (not the appraisal). The Project Loan Amount is the amount of loan that the project (collateral for the loan) will support. Although the appraised value is important, it is best that you forget the appraised value and focus on the Project Loan Amount. The formula for calculating the Project Loan Amount is as follows: (1) divide the NOI by the Debt Coverage Ratio. In our example above $131,635 divided by 1.25 equals $105,308. (2) divide the $105,308 by 12 to calculate the monthly principal and interest "P&I" payment amount. (3) enter the monthly P&I of $8,776 into your calculator (in many calculators this figure must be changed to a negative). (4) enter into your calculator the interest rate and amortization (for this example we will use 10.00% interest and 30 year amortization). (5) solve for the Loan Amount (which will be $1,000,000 if you use the figures in our example). So, the Project Loan Amount for a project with annual NOI of $131,635 (using 1.25 debt coverage, 10% Rate and 30 Yr. Amortization) is $1,000,000. This is the way commercial lenders determine the loan amount. Commercial lenders will also limit their loan amount to a percentage of the appraised value and/or purchase price, whichever is less.

ESTIMATING MARKET VALUE - A good way (ball park) to estimate the Market Value of a commercial property is to first determine the Project Loan Amount, then divide the Project Loan Amount by .75. In the case of our example above, the Project Loan Amount is $1,000,000 and this amount divided by .75 is $1,333,333. The reason this calculation works is because most purchasers expect to be able to make a 25% cash down payment on a commercial real estate project and finance the balance, which would be 75% of the purchase price. In addition, few lenders will finance more than 75% of the purchase price of commercial projects (except apartments).

CAPITALIZATION RATES - These are normally used by appraisers. The way to calculate the capitalization rate "CAP rate" is to first secure annual operating statements on similar commercial properties, determine the NOI on the comparable "COMP" properties, then divide the annual NOI by the Sales Price. An average CAP rate for most commercial properties is 10%. In areas where there is a high demand for a particular type of commercial property, like apartments, the CAP rate for apartments might be 9%. On mobile home parks the CAP rate might be 11% and for motels the CAP Rate might be 12%. IF YOU DIVIDE THE CAP RATE BY THE NOI YOU WILL ARRIVE AT THE APPROXIMATE VALUE OF THE PROJECT. Actually, the CAP rate represents the annualized yield to the investor based on the sales price of the project. Many investors might say that they are seeking at least a 10.00% return on their investment, which would be a 10% CAP rate. For most commercial real estate projects you can quickly estimate their approximate value by dividing their annualized NOI (NOI is always annual) by a .10 CAP Rate. Thus, in our example above, if the annualized NOI is $131,635, the market value is going to be in the $1,316,350 range ($131,635 divided by .10 = $1,316,350). Note how this compares with the ball park method used above. Very close isn't it! If the annual NOI is $131,635 and the CAP rate is 9%, the value of the project would be $1,462,611 ($131,635 divided by .09 = $1,462,611). So, the lower the CAP rate means that the purchaser is paying a higher price for the project and the net yield to the purchaser (owner/investor) is lower.

BORROWER - The borrower's financial statement is not as important to the commercial real estate lender as the ability of the project pledged as collateral to support the payments (debt service) on the proposed loan. In other words, the commercial lender will look to the project to make the payments on the loan rather than considering the borrowers financial strength to make the payments. This is why most commercial real estate loans over $1,000,000 are non recourse (no personal liability). Lenders are very interested in the management company or the owners ability to manage the project because they want to make sure the project will continue to make the payments on the loan. The borrower and/or principals of the corporation will also need to have a good reputation in the industry, good credit and a respectable net worth commensurate with the size of the loan.

REMEMBER - All commercial projects are simply investments, like purchasing a certificate of deposit or a bond. When investors purchase commercial real estate they are interested in the return on investment (not the bricks and mortar). Don't make the mistake of getting attached to the project! Instead, focus on the net return the project produces for the owner/investor. The value of the commercial real estate project is determined by the net income it produces for the owner.