In negotiating an income property loan, the size of loan the borrower can obtain is usually more of a sticking point than the rate or the loan fee.
Since income property loan sizes are generally limited by the debt service coverage ratio (i.e., cash flow), rather than the loan-to-value ratio, the operating expense figure that the lender uses in his calculations is critical.
Suppose a property has the following Pro Forma Operating Statement:
ABC APARTMENTS
1234 MAIN STREET
SAN JOSE, CALIFORNIAPRO FORMA OPERATING STATEMENT
Income:
Gross Scheduled Rents $100,000
Less 5% Vacancy & Collection Loss 5,000Effective Gross Income: $ 95,000
Less Operating Expenses:
Real Estate Taxes $12,500
Insurance 2,550
Repairs & Maintenance 5,890
Utilities 7,345
Management 4,865
Fees & Licenses 987
Painting & Decorating 3,986
Reserves for Replacement 1,900Total Operating Expenses: 40,023
Net Operating Income: $54,977
Then we hereby define the Operating Expense Ratio as follows:
Operating Expense Ratio = Total Operating Expenses divided by
the Effective Gross IncomeUsing our example above:
Operating Expense Ratio = $40,023 ÷ $95,000 = 42.1%
Appraisers and professional property managers often keep track of the operating expenses of the buildings they appraise or manage, and they publish their results. For example, the National Association of Realtors publishes the results of their surveys annually in several hardbound books including Income and Expenses Analysis-Apartments and Income and Expense Analysis Office Buildings.
Lenders have access to these type of publications, and they therefore are reluctant to accept at face value operating expenses supplied by the borrower when their operating expense ratios are less than those experienced by similar buildings in the area.
While it might be possible to operate an apartment building IN THE SHORT RUN at an operating expense ratio of less than 30 to 45%, in the LONG RUN, the end result will be a seriously deteriorated building.
It might be possible to get a lender to accept an operating expense ratio as low as 28% on a very new building, if it had fewer than 10 or so units, and if it had no pool and very little landscaping, and if you had authentic source documents to back up your claim. But in general, lenders will very seldom accept an operating expense ratio on apartments of less than 30 to 35%, and have been often known to use 40 to 45%.
The following are factors that will influence the lender to use a higher operating expense ratio:
- Lack of individual metering of utilities
- Swimming pool
- Elevator
- Extensive landscaping
- Low income area and/or tenants
- Presence of families with children
The larger the project, the larger the required operating ratio. Large projects usually entail extensive recreational facilities and pools, and they often require full-time on-site management teams.
Operating expense ratios are not as useful in evaluating most commercial or industrial properties. The reason why is because the space can be rented on a triple net basis, a net basis, or a full service basis.
Certain commercial properties, however, have surprisingly predictable operating expense ratios”
- Self storage facilities: 25%
- Mobile home parks: 25%
- Non-flagged hotels and motels: 50%
- Flagged hotels: 60%
- Residential care homes: 85% (food, nurses, etc.)
If you are a commercial loan broker, and you are not calling every commercial real estate loan officer, working for a bank or credit union, within 20 miles of your office, you are missing out one of the biggest feasts in commercial real estate finance (“CREF”) in forty years. Please grasp this concept:
Almost every bank in the country is turning down almost every commercial loan request that it receives. Helloooo? What are they doing with these turndowns?
These bankers would welcome anyone who could help them service their high-net-worth clients, especially since you will be taking the deals to a private money lender, like Blackburne & Sons, as opposed to a competing bank, which might steal their client.
By George Blackburne
First a correction. A few days ago, I wrote a blog article about how deflation is sweeping the world. In that article, I mentioned that deposit rates in Germany are slightly positive. I am pretty sure that this statement was wrong.
Listening to Bloomberg today, I just discovered that the yield on ten-yield German bunds is a negative 0.46%. The world is deflating so fast that this yield fell by a full 0.02% in a single day. That’s a pretty big move. No wonder the Fed is trying to get ahead of deflation in America.
I couldn’t find the current yield on bank C.D.’s in Germany right now, but they simply must be negative because German banks are making hundreds of billions of dollars in commercial loans to large German businesses at a negative interest rate.
Holy crappola! Is this a wild and crazy world or what? This negative yield means that if you want the safety of loaning money to the German government, you have to pay the German government almost one-half of one percent per year for the privilege.
Now on to Today’s Training:
The Debt Yield Ratio is different from the Debt Service Coverage Ratio.
The Debt Service Coverage Ratio is a financial ratio, used when making commercial real estate loans, designed to determine if the property generates more than enough net income (typically 1.25x) to make the loan payments on the proposed loan.
The Debt Yield Ratio, in contrast, is a financial ratio, used when making commercial loans, designed to make sure that the amount of the new commercial loan never gets too large in relation to the net income thrown off by the property – no matter how low interest rates get. This latter point is critical.
In the lead-up to the financial crisis in 2008, conduits brought amazingly low interest rates on commercial loans to prime commercial real estate. Because interest rates were so low (in comparison to prior years) in 2005, 2006, and 2007 that investors were able to achieve historically sky-high loan-to-value ratios, sometimes as high as 80% loan-to-value!
Because the buyers of commercial real estate could now buy trophy properties with 80% leverage, thousands of wealthy investors poured into the trophy commercial real estate market. Up-up-up went prices. Down-down-down went cap rates. The property valuations and the size of the loans against them went crazy.
Bam! Then the Great Recession struck.
Down-down-down went the values of trophy commercial real estate. Borrowers defaulted on their huge CMBS loans. The bonds backed by commercial mortgage-backed securities (IOU’s backed by huge pools of commercial real estate loans) took horrendous losses.
After taking horrendous losses, the buyers of commercial mortgage-backed securities lost their appetite for these bonds. In 2009, the CMBS industry contracted almost out of existence. Dozens of conduit lenders (specialized mortgage companies originating commercial loans destined for securitization) closed their doors. It was a bloodbath. An entire industry – the conduit industry – was almost wiped off the face of the earth.
Finally – slowly – the appetite of CMBS buyers returned, but they were determined to never again invest in bonds backed by commercial loans that were far too large in comparison to the amount of net income being generated by underlying the property.
The result was the creation of the Debt Yield Ratio. At first, a conduit could not originate a CMBS loan with a debt yield of less than 10%. This kept most conduit loans at less than 60% loan-to-value.
Why would any borrower be content with a $7 million loan against his office building if the loan-to-value ratio was only 58%? The answer was that the conduits were the only lenders making non-recourse commercial loans.
Okay, life companies were also making non-recourse commercial loans, but their properties had to be breathtakingly beautiful. Conduits, on the other hand, would make large, non-recourse, commercial loans on average-looking commercial properties.
The new wave of CMBS loans performed spectacularly in 2011, 2012, and thereafter, so the appetite of CMBS investors became ravenous. More and more exceptions to the 10% minimum Debt Yield Ratio were made until 9% became the norm.
I am sure that conduit Debt Yield Ratios have fallen below 9%. Does anyone out there work for a conduit? What are conduit Debt Yields today?
This article was triggered by the rate sheet of a money center bank. Now this bank is a portfolio lender, rather than a conduit lender, but they recently publicized a minimum Debt Yield Ratio of 5% for apartments, 6% for commercial, and 8% for multifamily. Wow. The market is truly ravenous for commercial loans.
“Hey, George, recently I have heard commercial real estate loan officers talking about some new ratio called the Debt Yield Ratio. Is this just a shortened version of the Debt Service Coverage Ratio?”
Answer: No. The two ratios are totally different. The Debt Yield Ratio is defined as the Net Operating Income (NOI) divided by the first mortgage debt (loan) amount, times 100%.
Example:
Let’s say that a commercial property has a NOI of $437,000 per year, and some conduit lender has been asked to make a new first mortgage loan in the amount of $6,000,000. Four-hundred thirty-seven thousand dollars divided by $6,000,000 is .073. Multiplied by 100% produces a Debt Yield Ratio of 7.3%.
What this means is that the conduit lender would enjoy a 7.3% cash-on-cash return on its money if it foreclosed on the commercial property on Day One.
Please notice that the Debt Yield Ratio does not even look at the cap rate used to value the property. It does not consider the interest rate on the commercial lender’s loan, nor does it factor in the amortization of the lender’s loan; e.g., 20 years versus 25 years. The only factor that the Debt Yield Ratio considers is how large of a loan the commercial lender is advancing compared to the property’s NOI.
This is intentional. Commercial lenders and CMBS investors want to make sure that low interest rates, low caps rates, and high leverage never again push commercial real estate valuations to sky-high levels.
So what is an acceptable Debt Yield Ratio? For several years after the Great Recession, 10% was the lowest Debt Yield Ratio that most conduit lenders were using to determine the maximum size of their advances. That number has crept down to 9% today and occasionally lower.
In our example above, the subject commercial property generated a NOI of $437,000. Four-hundred thirty-seven dollars divided by 0.10 (10% expressed as a decimal) would suggest a maximum loan amount of $4,370,000.
Typically a Debt Yield Ratio of 9% produces a loan-to-value ratio between 65% and 70%, about the maximum level of leverage that the current CMBS B-piece buyers will allow.
It is the money center banks and investment banks originating fixed-rate, conduit-style commercial loans that are using the new Debt Yield Ratio. Commercial banks, lending for their own portfolio, and most other commercial lenders have not yet adopted the Debt Yield Ratio.
You will notice in my definition of the Debt Yield Ratio that I used as the “debt” just the first mortgage debt. The reason why I threw in the words first mortgage is because more and more new conduit deals involve a mezzanine loan at the time of origination. The existence of a sizable mezzanine loan behind the first mortgage does NOT affect the size of the conduit’s new first mortgage, at least as far as this ratio is concerned.
Will a conduit ever accept a Debt Yield Ratio of less than 9%? Yes, if the property is very attractive, and it is located in a primary market, like Washington, DC; New York; Boston; or Los Angeles – an area where cap rates are exceedingly low (4.5% to 5%) – a conduit lender might consider a Debt Yield as low as 8.0%.
Why did the conduit industry start to use the Debt Yield Ratio? For over 50 years commercial real estate lenders determined the maximum size of their commercial mortgage loans using the Debt Service Coverage Ratio. For example, a commercial lender might insist that the Net Operating Income (NOI) of the property be at least 125% of the proposed annual debt service (loan payments).
But then, in the mid-2000’s, a problem started to develop. Bonds investors were ravenous for commercial mortgage-backed securities, driving yields way down. As a result, commercial property owners could regularly obtain long-term, fixed rate conduit loans in the range of 6% to 6.75%, which was stunningly low rate from a historical perspective.
At the same time, dozens of conduits were locked in a bitter battle to win conduit loan business. Each promised to advance more dollars than the other. Loan-to-value ratio’s crept up from 70% to 75% and then to 80% and then up to 82%! Commercial property investors could achieve a historically huge amount of leverage, while locking in a long-term, fixed-rate loan at a very attractive rate.
Not surprisingly, the demand for standard commercial real estate (the four basic food groups – multifamily, office, retail, industrial) soared. Cap rates plummeted, and prices bubbled-up to sky-high levels.
When the buble popped, conduit lenders found that many of their loans were significantly upside down. The borrowers owed far more than the properties were worth. The lenders swore to never let this happen again. The CMBS industry therefore adopted a new financial ratio – the Debt Yield Ratio – to determine the maximum size of their commercial real estate loans.
I had an interesting conversation with a conduit lender this week, and he pointed out that conduit loans are now being priced according to their Debt Yield Ratio. For example, the interest rate on an office building loan might be priced at just 170 bps. over swap spreads if the Debt Yield Ratio is 10.0%, but the interest rate would be pegged at 185 bps. over swap spreads if the Debt Yield Ratio was just 9%.
Just a reminder from yesterday’s lesson, the interest rate on conduit loans is now computer based on the greater of U.S. Treasuries or swap spreads.