Banks are still making loans

by Ken Pirok
Business Consultant
www.kenpirok.com

Banks are still making loans. It may be a bit tougher to get approved these days, but low property values and low interest rates are creating opportunities in real estate. It is, perhaps, more important than ever to understand how banks approve commercial loans and to be savvy when it comes to applying for a mortgage.

Contrary to popular belief, the collateral value of your property is not the primary concern of the bank. Liquidation of collateral only happens when loans go bad. The primary source of repayment and the most important factor to your bank is cash flow. Most banks measure cash flow using the Debt Service Coverage Ratio.

Debt Service Coverage Ratio = Net Operating Income ÷ Annual Debt Service

Net operating income or "NOI" includes all cash income, expenses, and taxes, and it is presented on an annual basis. NOI excludes non-cash expenses such as depreciation, and it also excludes interest expense, since interest is included in the denominator of the ratio. For prior years, you will provide the bank with your actual numbers. For future periods, you should assume some reasonable amount of vacancy and bad debt in your calculations.

The annual debt service requirement includes all scheduled principal and interest payments on any mortgages for a property. Banks usually prefer to see debt service coverage of at least 125% as a cushion in case times get tough.

The secondary source of repayment is collateral, which is a backup to the bank. Banks measure the collateral value of properties using the loan to value ratio or "LTV".

Loan to Value = Mortgage Principal Balance ÷ Appraised Value of Property

Obviously, banks like to see loan to values of at least seventy-five or eighty percent, but sometimes if the cash flow looks good, and the property is marketable, a bank might loan even an even greater amount.

Here are a few hints to help you maximize the debt service coverage ratio or appraised value of your property. Tell your banker or your appraiser about any discretionary or unusual expenses. Maybe you paid your brother-in-law a lot more than the going rate to paint your property, or you provided extra landscaping and a garden at your apartment building, or maybe you donated money to charity. You can create "pro forma" financial statements showing what your cash flow would look like if you had not incurred such hefty expenses. You don't want to be penalized for going the extra mile.

Watch your depreciation too. If you have assets with accelerated depreciation schedules or if the IRS allows you a big write-off when you purchase a piece of equipment or remodel a unit, then tell your banker or your appraiser. They may add back some of the depreciation or expense to your NOI.

A third and final source of repayment to the bank is your personal assets and resources, which the bank ties up using a personal guarantee or by requiring your signature on the mortgage as an individual.

When you apply for a mortgage, the bank will ask you to fill out a personal financial statement, which they will use to measure your personal wherewithal. Before you turn this form in to them, be sure to double check your math. You would be surprised how many people submit numbers that just don't add up.

If you would like to learn more about commercial borrowing, visit www.kenpirok.com or call us at 217.840.7726.