What metrics go into evaluating and rating the attractiveness of a commercial mortgage?
Loan-to-Value (LTV) and Debt Service Coverage Ratio (DSCR) are the first two that come to everyone’s mind and they are great.
I use them everyday.
But they do have their flaws.
Today I’ll give you another mortgage metric to add to your arsenal. It’s my favorite and one I’m betting you’ve never heard of.
I’m also giving you 23 more formulas to measure you’ll want to keep close to your desk – it’s in our downloadable blueprint called The Periodic Table of Commercial Real Estate Formulas. Make sure to swipe it before you leave.
Ready to get started?
First, let’s talk LTV and DSCR….
The most commonly used metric is loan-to-value, or LTV.
It’s a great metric that helps lenders know how much of a cushion there is from their last dollar to the value of their collateral.
It provides a sense of the loan’s security.
So for example, if I have a 50% LTV loan, I would feel that loan is pretty secure. The collateral could lose half of its value and the loan would still be “money good”.
Write that term down — It means the exact opposite of underwater in mortgage terminology.
So what’s the biggest driver of LTV? Well, the property’s value.
Now property value is very subjective. In liquid markets for high quality institutional real estate, there may be a little more transparency and confidence in pegging a value for a property. But in illiquid markets with smaller assets, it gets trickier. It can change drastically by investor and the secondly, it can quickly change over a relatively short period of time.
Plus, I have seen arguments over asset values go on for weeks and you can have two pretty smart guys on each side of the table.
And I’ve also seen sponsors take a loan to market to multiple lenders at a specific $ request, and all of the lenders can peg it at different LTVs.
Let’s take a look at a real life example…
I was looking at a $20mm loan request for a retail property in New Jersey.
The sponsor put together a little package with the property details, pictures, and some financial performance stats. The financial numbers got pretty granular and all of the lenders were looking at the same exact details, pictures and numbers.
What fascinates me is that lenders derived property values from $26mm all the way to $30mm.
That’s a pretty big variance.
You’re going from a 67% LTV to a 77% LTV and, you guessed it, the “higher” LTV loan costs more money.
What’s funny is that each lender would be taking on the same exact risk because the property is exactly the same for everyone as well as the sponsorship. But each of these lenders has a different view on the value, which affects the LTV, which affects the perceived risk of the deal.
So lender 1 may call this a 77% LTV deal and say this that this is a high-leverage deal and may choose not to pursue as a result while lender 2 will call it a 67% LTV deal — standard deal.
(NOTE: Want access to The Commercial Investor business vault? Right now we’re offering access to systems, strategies, templates, trainings, and recordings. It’s all included in The Investors Syndicate, and all available to you here.)
Debt Service Coverage Ratio (DSCR)
DSCR shows the ratio of the property’s NOI over its debt service payments over one year.
If a property has an NOI of $8mm and annual debt service payments of $4mm, the DSCR is 2.0x.
A DSCR of 1.0x means that the NOI and the annual debt service payments are equal. If the DSCR is greater than 1.0x, that means the property generates sufficient cash to cover the debt payments.
And if it goes below 1.0x, that means that the borrower has to dig into his own pocket to pay the piper.
DSCR is a great indicator of term risk: risk that the borrower may not make a payment during the term of the loan (different than maturity risk).
So let’s say a sponsor is struggling making payments because he isn’t able to execute his plan or he’s just not that good, DSCR can get lower and lower as NOI weakens. Lenders (as long as they are monitoring financial performance on their collateral) see this and get worried because they know there is a higher likelihood of term default.
At what point does the sponsor say, “You know what, I’m tired of throwing good money after bad and I’m going to let it go.” Lenders stay up at night worrying about this but one way to catch before it gets to this point is tracking DSCR.
Here’s a great way to do this:
Many lenders may have a DSCR threshold that triggers a cash sweep.
What does that mean?
Let’s say the lender has a DSCR threshold of 1.5x. Now let’s say that the DSCR has been dropping from 2.1x to 1.7x to now 1.4x. Once it goes below 1.5x, lenders can institute a cash sweep.
That means that all excess cash flow after operating expenses and debt service is put into an account under the custody of the lender. Basically, the lender is reserving all this cash in the event DSCR falls below 1.0x and they can draw upon this reserve to pay the debt service.
Also, let’s say things get worse, this reserve is now cash collateral and stays with the lender if they were to foreclose.
The cash sweep using a DSCR trigger is powerful in minimizing risk. Plus, it incentivizes the borrower to stay above that threshold number because they don’t want to have their cash in the custody of the lender.
Now back to DSCR.
Loan amortization has a major effect on DSCR. An amortizing loan will have a much lower DSCR than a loan with interest-only payments, with all else being equal (rate, term, etc). So two 50% LTV loans with 10 year terms and 4.00% interest rates can have significantly different DSCRs if one loan is interest only and the other is amortizing on a 30-year schedule.
Playing with the amortization only shifts default risk from either the term to maturity or vice versa (I can talk to you about this another time).
Now let’s talk about my favorite mortgage metric…
Cash is King.
Always has been and always will be.
What is debt yield, you ask?
It’s the property’s NOI divided by the loan amount. Basically, it’s the mortgage’s cap rate. So if a lender needs to foreclose on the property, that’s their cap rate on the collateral.
What I love about it is that it cannot deceive you like LTV or DSCR. The property spits out a certain amount of cash (NOI) on an annual basis and that’s that. Knowing the property’s NOI gives comfort to the lender on how attractive their mortgage is.
Let’s go through some numbers:
Let’s say we have a $40mm office building with a $20mm first mortgage. This is a 50% LTV loan. Now let’s say the property’s NOI is $2.4mm. So from a valuation perspective, we are valuing this property as a 6% cap rate ($2.4mm NOI divided by $40mm valuation). And the debt yield on this property is 12%. We got that by taking the $2.4mm NOI divided by the $20mm mortgage.
It’s that simple.
Debt yields generally move with cap rates. So if cap rates are down 2% in a specific market over 2-3 years, expect debt yields to be similar.
At the end of the day, it comes down cash flow.
And as good as DSCR and LTV are, the one metric you can hang your hat on is debt yield because…
Cash is King.
Are you using debt yield in your metrics? Let me know in the comments.
(Before you go, don’t forget to download our blueprint of The Periodic Table of Commercial Real Estate Formulas.)
NOTE: Want access to The Commercial Investor business vault? Right now we’re offering access to systems, strategies, templates, trainings, and recordings. It’s all included in The Investors Syndicate, and all available to you here.