TODAY’S COMMERCIAL FINANCING MARKET

One of the most important aspects of purchasing commercial property, more so now than ever, is the ability of the Purchaser to secure mortgage financing. With the development and spread of the “Credit Crisis” over the past 18 months, several challenges have emerged, or re-emerged depending on how far back in time you go.

One of the most significant developments in the commercial financing world is the disappearance of “Equity Lending” at higher loan to values and at the lowest interest rates. Equity Lending is generally recognized as the mortgagee lending against a property based on it’s perceived value typically arrived at via an appraisal. The Lender would accept the property’s value being based on the “theoretical” economic rent it could generate, regardless of the actual economic rent it was currently generating. This seemed reasonable so long as the Borrower could substantiate the ability to service the debt and property values were rising.

In today’s financing world this no longer exists. In general, Loan to Value (LTV) ratios have not only decreased to 65% - 70%, they are used in conjunction with the economic rent the property is CURRENTLY generating. Lending institutions are now doing their own valuation of the property by applying a “capitalization rate” acceptable to them to a proven Net Income stream which they have discounted heavily for vacancy and quality of Tenant.

Example:

The Borrower purchases a building for $1,538,000 generating Net Income of $100,000 which equates to a 6.5% Cap. Rate. The Lender feels comfortable with a 7% cap rate, which when applied to the income stream produces a value of $1,428,000. All things being equal, the Lender agrees to a Loan to Value of 70% of the Lender’s value, not the Purchase Price. As a result, the Borrower must come up with the additional $110,000 cash because the Lender has based the mortgage value on the $1,428,000, NOT the purchase price of $1,538,000.

Borrower: Net Income $100,000
Cap Rate 6.5%
Purchase Price $1,538,000 ($100,000 / 6.5%)

Lender: Net Income $100,000
Cap Rate 7%
Property Value $1,428,000 ($100,000 / 7%)

Mortgage: 70% of $1,428,000, NOT the purchase price of $1,538,000.

Furthermore, Lenders have increased the amount by which they discount the Net Income stream for the purpose of Debt Servicing. This measure is called a Debt Coverage Ratio (DCR) which has been increased in general to 1.25 from 1.10. This means the amount of proven Net Income which is used to service the debt is being reduced by approximately 25% instead of 10% for the purpose of paying the monthly mortgage payment.

Example:

Net Income $100,000
DCR 1.10
Debt Servicing $’s $90,900 ($100,000 / 1.10) annually, $7,575.00/month

Net Income $100,000
DCR 1.25
Debt Servicing $’s $80,000 ($100,000 / 1.25) annually, $6,666.66/month


In essence, the Lenders are reducing the amount of the Net Income they will allow, on paper, to be used for Debt Servicing. This reduction results in a lower mortgage amount being available and a substantially higher cash contribution by the Borrower. Now imagine this scenario playing out when a borrower needs to refinance an existing loan based on the old valuation methods!