Now is a great opportunity to invest in commercial real estate in Washington, DC especially retail real estate. Retail vacancies are dwindling and retailer expansions are on the rise. However, the ongoing challenge is finding lenders willing to make reasonable term loans. Before any commercial real estate contract is considered, savvy buyers crunch the numbers multiple ways but also understand the criteria lenders will use for making their decisions about lending.
Most commercial lenders use two basic criteria for making their decision about lending 1) The ability of the property’s income stream to service the loan and 2) The adequacy of the property’s value as collateral for the loan.
To illustrate the use of such criteria, we investigated 633 Pennsylvania Avenue SE as the the subject property and calculated the Net Operating Income(NOI) to be $125,000. Based on Capitol Hill retail rates, the tenant, Locanda pays about $73 gross per square foot. The taxes are $14,000 annually. Using an 8.0% CAP rate, the property is valued at $1.56 million. Assuming the available loan-to-value ratio(LTV) is 75%; a loan of $1,170 million is determined using the collateral value methodology.
However, property value is not the only criteria used for making loans. Equally if not more important is the ability of the property’s income stream to service the debt. And just as the LTV ratio provides a collateral cushion, lenders demand an ability to service cushion. That cushion is determined by the debt service coverage ration(DSCR) which is Net Operating Income(NOI) divided by Debt Service. To Illustrate the use of DSCR, I again used 633 Pennsylvania Avenue SE valued at $1.56 million. Most lenders will require at least a 20% cushion between NOI and debt service, that is, a DSCR of 1.20%. Given the first year’s NOI of $125,000 and the DSCR of 1.20, the maximum debt service the property can support is $104,166. This amount, $104,166 is now used to calculate the maximum loan amount. The amount of debt service divided by the original loan produces a percentage called the mortgage constant. Assuming the mortgage constant is 12% and given the debt service of $104,155 the justified loan amount is $1,134 million.
In practice, most lenders will calculate both measures and use the lower more conservative loan amount. This means the buyer will get a loan of only 1,136 million which is $34,000 less than if only the LTV ratio is used.