How Do Lenders Analyze Real Estate Investment Properties?

With regards to financing, you are looking at an income-producing, or "IPRE" commercial real estate loan.

First off, what does "income-producing" mean?

When a bank refers to "income-producing" commercial real estate, they are talking about the fact that the loan will be repaid by rental income collected from third-party tenants.

For example, let's say that Jane Doe owns a commercial building located at 1 Main Street. Jane leases the building to John Smith, who manufactures widgets in the building. So, John is the tenant at 1 Main Street and pays rent to Jane Doe (the landlord) for use of the property. Because John is a third-party tenant (not an owner of the property), this is considered "income-producing" commercial real estate.

Loan Repayment

Why does a lender care if a property is owner-occupied, or occupied by a third-party tenant?

Lenders analyze these loan requests differently when it comes to repayment of the loan. For an income-producing commercial real estate loan, the lease income is going to drive repayment of the debt. In the example above, the lease income paid from John Smith to Jane Doe is what truly drives the repayment of the commercial real estate loan. Most traditional banks are going to analyze the overall property cash flow, as well as all of its debt obligations. The primary metric they use is called the Net Operating Income Debt Service Coverage ratio. 

Net Operating Income Debt Service Coverage Ratio

• Gross Rental Income = The total annual lease payments collected from tenants
• Vacancy & Collection Expense = Even if a property is fully-occupied, lenders often include a deduction to allow for current or expected future space that is not rented due to tenant turnover and losses from uncollected rent due from delinquent tenants.
• Effective Gross Income = Gross Rental Income less Vacancy & Collection Expense
• Operating Expenses = The annual expenses to own and operate a property like property taxes, utilities, insurance, management fees, etc.
• Net Operating Income = Effective Gross Income less Operating Expenses. This is the Annual Net Profit generated by the property (keep in mind that this is before Depreciation, Amortization and Interest Expense).
• Annual Debt Service = The total annual principal and interest payments on the commercial real estate mortgage. An easy way to calculate this by taking the monthly payment on the prospective loan and multiplying that by 12.
• Net Operating Income (or "NOI") Debt Service Coverage Ratio = Net Operating Income divided by Annual Debt Service
  

An NOI Debt Service Coverage ratio of greater than 1:1 indicates that the property generates enough cash flow to cover what the debt service will be on the prospective loan.

Quality & Length of Leases

Lenders often take into consideration the leases in-place. For example, the length of the lease is relevant. If you are applying for a ten-year loan, but the lease you have in place with your tenant only has six months left on it, the lender will often address that (are you negotiating the renewal with the tenant, are there other prospective tenants in the market that you could lease to, etc.).

Collateral

In addition to analyzing your ability to repay the loan, the lender is often going to analyze the collateral. 

Below are the most common factors lenders consider with regards to collateral:

• Loan-To-Value = The loan amount divided by the value of the property
• The Age of the improvements and estimated "Remaining Economic Life" of the property. 
• It is important to note that many lenders will base their loan amount on the lesser of Appraised Value or Purchase Price.
• For example, let's say you are purchasing a property for $250,000. The appraisal comes in with a value of $300,000. Even though the appraised value is higher, the bank may only base their loan amount on the $250,000 figure.

Environmental

Another aspect to collateral is the environmental condition of the property. For example, the lender will likely want to know how the property has been used in the past (was it used as a gas station for example? Or have hazardous materials been stored on the property? Etc.). With regards to the environmental condition of a property, lenders not only care about its marketability, but the possibility of being held liable for something that goes wrong. 

Title

When analyzing a real estate secured loan request, a lender is going to review a document called a Preliminary title report. This document essentially shows who the owner of the property is, any liens against the property, easements, or any other items that would have been recorded against the property. Any of the items listed above could impact the lender's "priority" position on the property, and a lender will likely want you to get outstanding issues resolved prior to funding a loan.

If you have a potential commercial real estate acquisition, we would love to help you analyze your financing options.