Think Like a Lender: 7 Rules of Thumb Lenders Use to Size a Loan

//Think Like a Lender: 7 Rules of Thumb Lenders Use to Size a Loan

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Think Like a Lender: 7 Rules of Thumb Lenders Use to Size a Loan


Why Lender Rules of Thumb are Important

One of the more common mistakes of investing in commercial real estate is not fully understanding the importance the lender has on a property’s return on investment.  Now I know what you’re thinking.  “Doug, of course the lender is important to a property’s ROI.  The lower the interest rate the higher the ROI.  Duh.”  Yes, that’s true but that’s not what I’m referring to.

Maybe even more critical to a property’s return on investment is the size of the loan.  It’s the lender that ultimately determines the loan size.  Not the pro forma found in the marketing flyer, nor the buyer’s proposed budget.  It’s the lender.  And without having an accurate estimate of the loan amount, the buyer doesn’t know how much cash is required at closing.  And how much equity that’s required to purchase the property is a key factor in determining the property’s cash-on-cash return.

This is not an academic exercise.  As an investor the sizing of the loan is a critical component for calculating the property’s return on investment.  That’s why it’s important to understand that lenders have rules of thumb that they use in their underwriting guidelines.  It has the potential of significantly affecting the property’s cash-on-cash return.  Not all lenders have the same rules of thumb.  That would be too easy.  No, each lender sizes the loan differently but generally there are seven rules of thumb that most lenders will use to determine the loan amount.

As capitalization rates continue to decline, loan sizes are more and more being constrained by the lender’s debt coverage ratio instead of their loan to value ratio.  This puts additional importance on understanding these rules of thumb.

The 7 Lender Rules of Thumb

They are:

  1. Annual Rental Income – lenders in most instances use the current monthly gross potential rent (with vacant units at market) x 12 months. With sharply increasing rents these past few years, many investors and CRE professionals like to use current asking rents also called turnover rents.  They’re reasoning is that current market rents have been proven and as soon as the other tenants’ leases expire they will increase the rents to market.  And that may make sense from the buyer’s point of view but lenders generally only use the gross potential rent found on the most current rent roll.
  2. The Vacancy Rate is determined by taking the lower of: a) the actual vacancy at the property; b) the current vacancy rate in the market for that property type; or c) 5 percent. These days with the tight vacancy rates, especially in apartments and industrial properties, investors like to use a vacancy rate less than 5 percent.  And again that might make perfect sense but lenders are not known for common sense are they?  They are a conservative lot so the best vacancy rate they will use is 5 percent.
  3. Other Income is limited to those types of income that are easily quantifiable. For apartments that would mean garage income, storage income, laundry income and utility reimbursements.  For other property types, CAM reimbursements would fall into this category.  But income from late charges, application fees, pet rent, damage reimbursements, etc. will not be used.      
  4. Most Operating Expenses such as property taxes, insurance, utilities, etc. are increased 3 percent over the previous year. There are exceptions to this rule of thumb, specifically with Repairs & Maintenance and on-site payroll and off-site management expenses as shown below.
  5. Repairs & Maintenance – for apartments this would also include turnover expenses and landscape maintenance. These types of expenses can vary greatly from one year to the next.  Lenders will do one of two things: a) they will average the past 2 or 3 years; or b) they will defer to what’s found in the appraisal.  Depending on the age and size of the property I generally use $500 per unit for Repairs & Maintenance, $200 per unit for Turnover Expenses and $300 per unit for Landscape Maintenance.  For other property types, I use an historical average for repairs and maintenance.
  6. On-Site Payroll and Off-Site Management Expenses – for apartments most lenders will use as a rule of thumb between 10 to 12 percent of Effective Gross Income for these two expense categories. For other property types, lenders will follow what’s shown on the property’s historical operating statements
  7. Capital Expenditures – for apartments, lenders will use no less than $250 per unit. If the property is older or has significant deferred maintenance it could go much higher.  For other property types it’s a crap shoot what they’ll use.  Surprisingly, many lenders will not include any CapEx in their projection of expenses.

Do Your Homework: Think Like a Lender

Adjusting the property’s income and expenses with these 7 rules of thumb has the potential of significantly decreasing the property’s projected cash flow before debt service.  As an investor you need to think like a lender when it comes to sizing the loan.  To avoid being unpleasantly surprised when you get your lender quotes go through the exercise of applying these rules of thumb to your pro forma.  At the very least ask each lender how they will underwrite the loan.  What are their specific rules of thumb for sizing the loan?

With that information in hand ask yourself whether the lower loan amount that a typical lender will offer kill the deal by:

  • Requiring more equity than you want to invest in the property?
  • Or will the additional equity in the property reduce your cash-on-cash return below a level you find acceptable?

If so, isn’t it better to find this out early on in the buying process?  Wouldn’t you rather know this important piece of the investing puzzle prior to getting it under contract?  Thinking like a lender will help you avoid wasting time and energy on a property that no longer pencils because the loan is lower than you hoped to receive.  Do your homework.


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