Investing in commercial real estate offers a strategic advantage through the use of leverage, where borrowed capital can be employed to fund a significant portion of an asset’s purchase price. This utilization of debt, known as positive leverage, is aimed at magnifying the overall investment returns.

To assess the feasible debt load for a property, commercial real estate lenders thoroughly analyze both the present and projected future cash flows associated with the asset. This meticulous evaluation is crucial to determine the responsible amount of debt that can be extended for the asset’s acquisition without exposing the owner to the risk of future mortgage default due to repayment difficulties.

Investors and lenders closely consider a series of key lending metrics when determining the maximum debt that a property can support, both in the current context and looking ahead. Some of these metrics are particularly relevant for stable assets expected to appreciate in line with market trends, while others are applicable to value-add projects that require additional capital to achieve stabilization in the future.

• Debt Coverage Ratio (DCR) is a crucial metric used by lenders to determine how much mortgage a property can handle, primarily when it’s stabilized. It assesses the property’s ability to cover its mortgage payments based on available cash flow. Most lenders require a minimum DCR of 1.20 to 1.25 to reduce the risk of default. When the property isn’t stabilized, the DCR helps evaluate how much interim financing the property can support from its current income. A DCR below 1 indicates that some form of financial support, such as an interest reserve, is needed to cover the mortgage until the property stabilizes.
• Loan to Value (LTV) is how lenders evaluate real estate by considering the purchase price or appraised value. The LTV ratio, based on predetermined guidelines, determines the loan size. For instance, a 75% LTV means a loan of 75% of the property’s value. If an asset isn’t stable, the lender may underwrite based on the property’s stabilized value but may release funds incrementally to aid in achieving stability.
• Debt Yield (DY) is a metric focused on lenders, akin to a cap rate but based on net operating income in relation to the loan amount rather than the property’s value. Some lenders, especially securitized ones, use this metric because it’s crucial for their potential return in case of foreclosure. It represents the return they’d get if they took over the property at the loan amount, considering the current net operating income. For example, if a property generates $1,000,000 in net operating income, and the lender provides a $10,000,000 loan, the debt yield would be 10%.
• Loan to Cost (LTC) is a crucial measure for lenders in value-add and construction projects. It assesses the loan amount relative to the total project cost. To ensure borrowers invest their own capital, lenders use a more balanced approach by considering both future LTV and LTC, choosing the lower of the two ratios. This prevents over-financing and ensures that borrowers have a financial stake in the project’s success.
• Loan Constant is a crucial metric that reveals the annual cost of a mortgage relative to the loan amount. It helps determine if the debt positively or negatively impacts the project’s overall returns. Projects with high LTV, high LTC, low stabilized DY, and low stabilized DSCR carry higher risk profiles in terms of debt and may face a greater risk of default if they don’t meet expectations or encounter market challenges. It’s important for both borrowers and investors to consider these metrics to assess the risk associated with an investment opportunity.