Real Estate underwriting is the process mortgage originators use to decide whether or not to approve a loan. In order to do this the lender evaluates the classic 5 C’s of Credit, Cash flow, Capacity, Collateral, and Conditions.  Two of the most commonly used underwriting tools are the Loan to Value ratio and the Debt Service Coverage Ratio. Other important underwriting tools will be covered in Part II of this Blog.

Loan-to-Value Ratio (LTV)

This metric is computed by taking the loan amount requested and dividing it by the appraised value of the property. For banks and institutional lenders such as Life Insurance Companies this is one of many factors to be considered.  For private money lenders this is the single most important factor in their making a go/no go decision on funding a loan request.

Since the severe recession of 2008-2010 the LTV ratio required by conventional lenders has undergone a significant change.  Prior to the recession (during what some would call the commercial real estate “bubble”) banks were often willing to loan up to a 90% LTV ratio.  When commercial real estate (CRE) values fell dramatically during the recession this extremely high LTV led to banks frequently taking severe losses on their CRE portfolios. Under pressure from both Federal Regulators (such as the FDIC and OCC) banks have dramatically lowered their LTV requirements and now rarely lend over 80% LTV with 65% or 70% LTV requirements frequently imposed.

Paradoxically, private money lenders before the recession limited their loans to 60% to 65% LTV and still maintain this requirement today.   The LTV ratio also is the basic tool used to understand the basic capital structure of the loan by revealing the debt to equity ratio.  The LTV ratio is also used interchangeably with the term” financial leverage” of a property.

Debt Service Coverage Ratio (DSC)

The DSCR – normally abbreviated as DSC – divides the annual Net Operating Income (NOI) by the total annual Debt Service – including principal, interest and all escrows such as tax and insurance. This is a fundamental ratio because lenders must know where money to pay the debt service will come from, and in income property, this income typically comes from the net income generated by the property after subtracting operating expenses.  Banks and institutional lenders are highly unlikely to approve a loan unless the DSC ratio is 1.2 or more.

Hard money lenders using private capital are generally much more user friendly in regards to the DSC ratio requirements.  If a hard money lender determines that the DSC ratio is not sufficient to cover the debt serviced (i.e. is under a 1.0 figure) they can build what is called an “interest reserve” into the loan which allows them to reserve some funds from the loan proceeds and use these reserved funds to pay that part of the debt service that is not generated by the net operating income of the collateral property.  This flexibility of the private money lender is one of the more common reasons why borrowers use this type of financing vs the bank loan.

The LTV and DSC ratios discussed above are the two most important tools used for initial underwriting review.  Other underwriting tools will be discussed in Part II of this Blog.

[google_authorship], because of his more than 40 years of experience in funding hard money loans, is considered an authority on hard money or bridge financing.  He frequently speaks at meetings and conferences and writes articles on these subjects.