In my last article, I discussed how lender recourse, prepayment penalties, a loan’s assumability, and fees and costs affect a real estate investor’s strategy. In this continuation, I will explore several other loan characteristics such that you can more successfully plan your next investment project.
Many commercial loan products offer fixed interest rates for some period of time before switching to an adjustable rate. The length of this time frame can vary based on several different factors. As a rule of thumb, the longer the fixed period, the lower the investor’s risk. Keep in mind, however, that a loan product with a long fixed period may be of little value when used to finance short-term projects. This can prove to be a determining factor when shopping around for the best loan product for your application; don’t pay a premium for a super long fixed period if you won’t need it.
Loan-to-Value Ratio (LTV)
The Loan-to-Value Ratio (LTV) is determined by dividing the loan amount by the sales price or appraised value, typically expressed as a percentage. Thus, a building purchased for $2,000,000 with a $1,600,000 loan has a LTV of 80%. Loan products may offer a maximum LTV from anywhere within the range of 70-85%. This ratio is extremely important to investors because the higher a loan product’s LTV, the less an investor’s capital outlay. Thus, the investor increases his leverage and his potential returns as the maximum LTV increases. Of course, when considering LTV, a limiting factor is often the…
Debt Service Coverage Ratio (DSCR)
Debt service coverage ratio (DSCR) is the ratio of Net Income to Annual Debt Service. Typically, the DSCR ranges between 1.15 and 1.25. The minimum DSCR is a loan-sizing factor just like LTV. For an investor looking to maximize his leverage, either DSCR or LTV will be his limiting factor.
Investors are best served looking for a loan product with a low DSCR. This is significant because it allows investors to acquire properties with less of their own equity capital and increase leverage and potential return.
A loan’s amortization period is the length of time required to repay an entire mortgage. This period is typically between 15 and 30 years; however, loan products exist with amortization periods as long as 40 years. For a given loan amount, as the amortization period increases, the lower the required periodic payment. Thus, yearly debt service decreases and cash flow shoots up. Similarly, for a given DSCR, as the amortization period increases, an investor qualifies for more loan dollars. More loan dollars means more leverage and, potentially, greater returns! Consider long amortization periods as you search for the perfect loan.
Finally, let’s explore interest rates. Surely, this is the most obvious loan characteristic that investors consider. What isn’t so obvious is how the interest rate ties all of the aforementioned variables together. For example, a lender may offer longer amortization periods, but it will surely cost you in terms of interest rate. In another example, a lender may offer a non-recourse loan, but that lender will almost certainly charge a slightly higher interest rate than for a similar, recourse loan. See where I’m going with this?
As a rule of thumb, tipping a loan characteristic in the favor of the borrower will have some negative impact on interest rate. With so many different loan variables, it can be difficult to determine which loan product is best suited for an investor’s project. While the search is tedious, it is certainly worth it. Happy investing!