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. (more…)