How does the loan-to-value (LTV) ratio affect the DSCR and the interest rate of a commercial loan?

In structuring credit, there are levers to pull and puttons to push to create a scenario that is acceptable to the borrower and to the lender. One of those levers and buttons is the loan-to-value ("LTV") ratio. The lower the LTV the more likely a lender will be to a) grant the loan request and b) offer more attractive terms to a borrower.

The Loan-to-Value (LTV) ratio is a financial metric used in the context of real estate and lending. It represents the ratio of the amount of a loan (mortgage) to the appraised value or purchase price of a property. In other words, it measures the percentage of the property's value that is financed through a loan. The LTV ratio is commonly expressed as a percentage and is calculated using the following formula: LTV Ratio = (Loan Amount / Property Value) * 100 For example, if you are buying a house valued at $200,000 and you secure a mortgage of $160,000 to fund the purchase, your LTV ratio would be: LTV Ratio = ($160,000 / $200,000) * 100 = 80%

In the not so distant past (2021) when interest rates on commercial loans were historically low, lenders were lending at a higher loan-to-value ("LTV") ratio, such as 75% on investment (also known as income producing property or "IPP") commercial real estate ("CRE") and 80% on owner-occupied ("OO") CRE. Back then, when analyzing debt using low interest rates, often the debt service coverage ratio ("DSCR") would be at a ratio that the lender would be comfortable with, such as 1.30 on investment CRE and 1.20 on OO CRE. However, today (2023) higher interest rates push down the DSCR which size the loan at a lower loan amount (than if an interest rate was lower), and as a result LTV ratios are much lower (65%, 60%, etc).

The Debt Service Coverage Ratio (DSCR) is a financial metric used in real estate and finance to evaluate the ability of an income-generating property to cover its debt obligations, primarily loan payments. The DSCR is typically expressed as a ratio and is calculated using the following formula: DSCR = Net Operating Income (NOI) / Annual Debt Service (ADS) Net Operating Income (NOI) represents the income generated by the property after deducting all operating expenses but before accounting for interest, taxes, and loan payments. Annual Debt Service (ADS) includes all the principal and interest payments required on the property's debt over a year.

A DSCR of 1.0 means that the property generates just enough income to cover its debt payments, indicating a breakeven point. A DSCR greater than 1.0 indicates that the property generates more income than needed to cover debt obligations, which is generally seen as a positive sign. A DSCR less than 1.0 means that the property's income falls short of covering the debt payments, signifying a potential financial risk.

While the LTV ratio doesn't directly impact the DSCR, it can indirectly influence a property's financial health and its ability to maintain a healthy DSCR. A high LTV ratio can put more pressure on the property's cash flow, potentially affecting its DSCR, while a lower LTV ratio may make it easier to maintain a favorable DSCR.

The Loan-to-Value (LTV) ratio indirectly affects the Debt Service Coverage Ratio (DSCR) in real estate: 1. A higher LTV ratio can lead to larger initial debt service, potentially affecting the DSCR. Interest costs tied to the LTV ratio impact the DSCR. 2. Changes in the LTV ratio during refinancing can alter the DSCR. 3. A high LTV ratio can strain cash flow and affect the DSCR, while a lower LTV ratio may support a healthier DSCR.

One other Important factor is Market Rent. Market rent is determined by the appraiser through analyzing gross rent comparables in the immediate neighborhood. If you are renting below market rent the lender is going to use the actual rent and this will lower your DSCR. Be sure to keep an eye on market rent and increase rent accordingly when it is time to renew the lease agreement with your tenants.

6 steps to optimize the LTV and DSCR for your loan: 1) Identify the maximum amount of equity capital you can commit to the investment. 2) Ask the lender for the maximum required LTV and minimum required DSCR. 3) Ask the lender their rates for different loan amounts. 3) Estimate the expected return on the asset being financed. 4) Calculate the return on equity for different loan amounts using the expected asset return and the lender's rate for different loan amounts. 5) Assess the risk you want to take in exchange for a higher return on equity. This is generally achieved at higher loan amounts, but it could be at a lower loan amount if the expected return on asset is less than the borrowing rate. 6) Hammer out your deal!

These are great thoughts and practices. During my years in commercial banking and 10+ years doing MBL review work I always found it wise to: apply USPAP standards to the appraisal, apply a current "cap" rate to the NOI to double check the appraisal, look behind the NOI to determine the accuracy and reliability of the income and NOI such as lease terms of current tenants, expenses, age, surroundings, history, appearance of the property and cost documentation to the prospective borrower. Make sure the lender is not over funding the asset value.