The Three Main Ratios Used In Commercial Lending
In order to perform the correct Underwriting Analysis, the Lender will subject the loan to 1 or more of the 3 most common ratios. The processing of the loan will involve the scrutiny and verification of all of the numbers being submitted with the documentation.
Understanding these ratios can be extremely advantageous to a borrower so that they know how to analyze and present their financial numbers to a Commercial Real Estate Lender. In addition, some lenders may also want to review business plans and operations plans to confirm the business has a viable chance of succeeding as a business and able to repay all loans that are involved.
The three main rations used in commercial lending are typically the following:
- Loan to value ratio
- Debt ratio
- Debt service coverage ratio or DSCR
We will explain these ratios in more detail for our readers.
Loan to value ratio – this is the ratio of your loans to the value of your property. The lender will need a recent appraisal of the property completed by an agent who is recognized as a commercial appraiser.
In some cases several appraisals might be needed to establish an average value. Lenders vary in the ratio levels that they are willing to consider. Some will approve loans as high as 90%, however most are capped at a 75% or 80% level. They want the owner to have money invested in their business or have some skin in the game as some might put it.
Debt ratio – this ratio can be a bit more complicated. Normally the debt ratio is the personal monthly debt payments divided by the personal monthly income. For home purchases, a ratio of 35% is typical. In the case of a business, the lender will be looking for the total monthly debt payments plus expenses divided by the businesses total monthly income.
The lender will do a number of sensitivity assessments which can include the total income of the person and the business as well as the total monthly payments and expenses to come up with a global ratio. They will also sometimes complete a stress analysis of these numbers to assess the impact and ability to service the loans. For example, they might increase expenses by 10% and decrease income by 10% to see what impact this would have on the debt ratio.
Business owners should select their own sensitivity assessment to assess their risk and to anticipate what the lender will be looking at.
Debt service coverage ratio or DSCR – this is a ratio of the net operating income divided by the total debt service or monthly payments. For example if you are purchasing a rental building, the net operating income will consist of the total rent income less the expenses to operate the building on a monthly basis. The total debt service will be the total of all outstanding loans that may be currently on the property plus the loan that you may be applying for.
The monthly net income is divided by the total monthly debt payments for all loans. Ratios that lenders are looking for typically should be in the range of 1.2 times. Again sensitivity analysis should be completed by the business owner to assess the impact and to prepare for questions and comments posed by the lender. Decreasing your net operating income by 10% and increasing your debt service level by 10% to reflect changing expenses and increasing interest rates is an example of what might be considered. Exact details will depend on your particular business area.
Commercial lending for Existing Businesses
Business owners who are applying for a business loan for a business that has been in operation for a number of years have the advantage in that they have some history of how the business is doing and can support their current rations with actual results. This makes the job of applying for a loan and supplying the numbers needed to calculate the rations much easier. The lender still may ask for projections of your income and expenses for the period of the loan. Typically these projections will be based on past history plus your view of what the future is going to bring.
Where it can get more complicated is when a major departure from your current business is planned. You may be expanding into a new territory for example, or adding a new product line. While you have the existing business to support you, the additional business activities may or may not support your current ratios. In addition to sensitivity analysis mentioned earlier in this post, both business owners and lenders may want to apply even more drastic sensitivity analysis to test the impact on the company’s ability to repay the loan, should this new business opportunity not measure up as projected.
New Business Opportunities and Commercial Lending
Start ups have the most difficult time in obtaining financing for their product development and operations expenses. The owner has a vision of what he or she wants to do and must convince a lender or in many cases a potential investor of his vision along with the business plan that he or she has developed.
The same ratios apply as before, but the sensitivity studies are even harsher. In addition the products that are being developed or that will be sold to the public may also be submitted to very stringent analysis to determine if there is sufficient demand to meet the sales forecast. The business plan will provide an outline of all aspects of the business including all cash flows that support the request for a commercial loan.
The main elements of this business plan will include the following: development costs, sales forecast, production costs, operations costs (packaging, shipping and installation if appropriate), support costs and warranty. Each area must be supported by a plan that lays out how these activities will be provided and how many people along with the costs will be determined.
All areas are subject to scrutiny by the commercial lender. If the ratios do not measure up to expectations, if the sensitivity analysis suggests there is too much risk associated with the business or if the lender feels that insufficient preparation and planning has not been completed for the business startup, they may decide to forgo approval of the commercial loan. The lender must have confidence in the management team to deliver the results they are forecasting.
With so many areas to question and review, it has been traditionally much more difficult to obtain a commercial loan for a start up business than for one that has been in operation for some time. The management teams commitment plays a key role in the ability of the company to obtain an approved commercial loan.