“It Depends”. These are the two words I frequently use when discussing a commercial mortgage. Whether it’s how much of a downpayment is needed, what the rate is, amortization, etc. It depends.
Let’s consider the first one; downpayment. How much does a client need to put down for a commercial property purchase? When determining this amount, the process isn’t as simple as it is for a residential deal but in some ways is very similar.
Please note that the following discussion pertains to when underwriting a deal based on the property’s cash flow and when dealing with a lender that will look to the rental income as the primary source of repayment.
With residential, the clients can get a preapproved mortgage by calculating how much they qualify for using their income and existing debts. They can then make a Purchase based on their Pre-Approved Mortgage plus their Downpayment.
Preapproved Mortgage + Downpayment = Purchase Price
With commercial, you really can’t get a preapproval since the mortgage is generally based on the income of the property and not the borrower – having said that, I can take the income and expenses on a commercial property and approximate how much of a mortgage it can carry, while not a preapproval, it can give you some guidance – contact me for details!
So you start with a Purchase Price and then work backward similar to a residential preapproval and end up with the Qualifying Mortgage amount and subsequent Downpayment. The process looks like this,
Purchase Price – Qualifying Mortgage = Downpayment
The best way to illustrate this is with a couple of examples. To make things simple I will be looking at conventional and not high ratio financing.
Please note the following terms:
- Net Operating Income or NOI
- Debt Coverage Ratio or DCR, DSC or DSCR
- Loan To Value or LTV
- NOI. This is the net income once all expenses pertaining to the property are deducted from the rent collected. Typical expenses can include, property taxes, property insurance, utilities, snow removal, routine maintenance, etc. There will also be allowances made for Vacancy & Bad Debt, Structural Expense and Management. Every deal is different and it depends on the specifics of a particular deal which expenses will be included. Note that these expenses do not include mortgage principal and interest.
- DCR. This is the ratio of the NOI to the mortgage principal & interest payments. Depending on the deal, an acceptable DCR would be as low as 1.10 (or 110%) to 1.30 (or 130%). This should always be greater than 1.00 or 100%. The ‘extra’ or excess over 100% is a cushion that gives the lender comfort to account for any interruptions in rent due to high or chronic vacancy, unexpected costs, etc that could reduce the income for a period of time.
- LTV. The ratio of the loan or mortgage amount to the lesser of Purchase Price or Appraised Value. ‘Rule of Thumb’ LTVs can range from 60% to 70% for most commercial deals and 75% for multi-family (m/f) properties. (Note this 75% for the example below). Each lender is different.
Clients are looking at purchasing a single-family dwelling. They are preapproved for a $562,500 mortgage (GDS/TDS are in line) and have $187,500 for the downpayment. Using the formula above,
$562,500 + $187,500 = $750,000
Pre-Approved Mortgage + Downpayment = Purchase Price
They can purchase a home valued at $750,000. This works out to an LTV of 75% ($562,500/$750,000). Assuming that the credit is good and the property is acceptable – the deal could be fairly straightforward.
Now let’s look at a commercial property selling for the same amount of $750,000 and again, the client has $187,500 to put down.
We’ll assume the subject is an 8-plex m/f. The subject is fully occupied with a rental income of $7,200/mo or $86,400/yr. Applicable expenses come to roughly $46,400/yr.
The NOI in this case is $86,400 – $46,400 = $40,000.
I’ll assume that the property is appraised at $750,000. As you will see below, the property value won’t be a factor in determining the mortgage amount. The driver will be the DCR.
Now here’s where they differ. In order to get an acceptable mortgage amount, we will use a trial rate (let’s go with 3.5%) and generate a P&I payment based on a 5 yr term & 25 yr amortization. Working backwards we make sure to stay within an LTV of 75% and a DCR of 130% (In this case – some lenders may go with 120%).
Trial and error yields a mortgage of $515,000, a DCR of 130% and an LTV of 68.7%. Using the formula above,
$750,000 – $515,000 = $235,000
Purchase Price – Qualifying Mortgage = Downpayment
So if they are buying the subject for $750,000 and the property qualifies for and can only support a mortgage of $515,000, the client will have to come up with a downpayment of $235,000 or $47,500 more than they have. As you can see, you just can’t take the purchase price and calculate an amount based on either 60, 65 or even 75% LTV. Furthermore, if the same property sold for $800,000, the mortgage amount is the same since the NOI doesn’t change and the client would now have to put $285,000 down (64.4% LTV).
In this case the client now has three options if they wish to proceed:
1) Come up with the difference from their own resources.
2) Secure a second mortgage. This will likely be at a higher rate & fees and note that the lender providing the first may have to approve allowing the second due to serviceability.
3) Look at an alternative lender (private, etc) that will do the full amount requested ($562,500) or even higher but at a higher rate & fees.
In summary, when calculating downpayment for commercial, treat it like a residential preapproval and work backwards.
- The ‘client’ would be the property and the ‘client’s income’ would be the NOI.
- The DCR would be the qualifying ratio much like the GDS/TDS.
- Once you have a ‘Qualifying Mortgage’ (ie. Pre-Approved Mortgage), then you look at the purchase price/appraised value for the difference.
Now I must stress that the numbers alone DO NOT determine whether or not you have a deal; they’re just a guide or an estimate to get the analysis going. As per the Mortgage Triangle I will discuss in a future post, the Income is one point that must be fully analyzed; there’s also the Real Estate and the Covenant.
I hope this helps give a clearer picture as to how the downpayment needed for a commercial mortgage is determined. As you can see, it depends.
If you have any questions or comments, please feel free to call me at 647.302.8065.
Now is the time to think commercial!
By: Ermanno Tasciotti | January 2018