Why CRE Lenders Don’t Care About Your Credit
by Karen Hanover
In commercial real estate (CRE) the property qualifies for the loan and not the investor(s). The lender is primarily concerned with whether the property can produce enough income to allow the borrower to make the mortgage payment.
If an investor buys a single family residence to live in, the property will generate no income. Therefore the lender qualifies the borrower with regard to the ability to make the payments.
Likewise, if an investor buys a residential property as a rental and the tenant moves out, the borrower will be required to make the mortgage payments until the property is re-rented. Therefore it should be no surprise that the lender is going to qualify the borrower with regard to the ability to make the payments.
A single family rental house is either 100% rented or 100% vacant. The lender will look at the worst case scenario (100 % vacant) and determine whether the borrower can make the payments from the employment income.
In CRE, it is the property that primarily qualifies for the loan and not the individual borrower. While CRE is purchased for potential appreciation, the actual cash flow called “Net Operating Income” (NOI) is what gives CRE its value. NOI is what lenders are considering when making a loan on a property with the individual borrower’s financial situation as a secondary consideration.
In CRE, the mortgage payments are referred to as the Annual Debt Service (ADS), and are made from the NOI of the property. Paying the mortgage in CRE is called “servicing the debt” or “debt service.” Rents are collected. Expenses to operate the property are paid. The remaining cash flows called NOI are available to service the debt.
Commercial property is rarely 100% vacant nor 100% rented. There are exceptions of course! In CRE, 10%, 20% or 30% of the property can be vacant and you may still have the cash flow necessary to service the debt.
The lender considers numerous factors when qualifying a property. What are the typical vacancy and rental rates in the area? How does this building compare to those rates? What is its current vacancy rate? How long does it typically take to get units rented? Even with vacancies does the property cash flow and if so, at what vacancy rate will it no longer cash flow? Whew! The lender has many considerations and not one of these was your FICO!
What the lender may look at is the investor’s character. In other words, if the NOI is sufficient to service the debt, will the investor use that cash to service the debt or will the investor buy a fancy new car instead? The lender may also consider the experience and track record of the investor. Does the investor understand how to operate this type of CRE and if not, has competent management been retained? That NOI must be protected!
The lender will also likely require the investor to retain a portion of the remaining NOI as "reserves". Most lenders will require those reserves to be deposited with the lender so they can be easily used to cover any unexpected shortage in cash flow, allowing the investor to continue to service the debt.
Additionally, the lender is going to apply a margin of safety in their loan underwriting to assure that the amount of debt service the investor is obligated to make is less than the cash flow the property produces. To do this, they will apply what is called a "Debt Service Coverage Ratio" also called "Debt Coverage Ratio"(DCR) to determine the amount they will loan on the property.
NOI / ADS = DCR
$100,000 NOI/$80,000 ADS = 1.25 DCR
DCR is defined as the ratio of annual cash flow to ADS. Lenders establish their own minimum DCR’s for the loans they make and it will vary between property type, location and borrower.
Typically lenders want to see more than a 1:1 ratio. This means that they want some amount of cash flow greater than the amount necessary to service the debt for the loan they make.
A commonly used number is 1.25. This means that they want to see 25% more cash flow than is necessary to service the debt of the loan they make. Using this ratio, NOI could decline by as much as 25% and still generate enough income to service the debt. Using this ratio as a rule of thumb and applying it to the actual cash flow of a property will give you some idea of how much a lender will be willing to lend on a given property.
In conclusion, commercial lenders base their lending decisions primarily on cash flow from the property and not of the financial strength or creditworthiness of the borrower. Additionally, they apply safety measures including the establishment of reserve accounts and a DCR to assure that the cash flow from the property will be sufficient to service the debt.
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