FAQ 4 -

How do lenders underwrite rental properties? 

It’s not an uncommon dream: Sell the co-op or condo apartment and buy a townhouse or a loft building. Live in it, collect rent and best of all, escape the sometime tyranny of co-op or condo life. If, however, the building being purchased has more than 5 apartments (and/or contains commercial space making it a "mixed-use" property), the cookie-cutter financing provided to buyers of 1 – 4 family homes disappears from the radar screen. If the buyers seek financing, they will be looking for a commercial, not a residential mortgage.

Many buyers assume that they can obtain financing for around 75% of the purchase price. The fact is that they can usually borrow about 75% of the property’s appraised value. Depending on a variety of factors, ranging from long-deferred maintenance to low rents being paid by rent-regulated tenants, there may be quite a disparity between the property’s purchase price and its appraised value. This can result in quite a surprise for a buyer who may need to provide considerably more equity than was initially expected. Today’s low interest rates are certainly helpful, but they will not necessarily result in higher loan amounts due to such valuation constraints.

It is common for a "gap" to exist between the premium price that a Manhattan brownstone or townhouse commands in the marketplace and its appraised value as seen “through a lender’s eyes”. Part of the explanation for the “gap” pertains to elements of ownership that will benefit an owner/occupant, but would be meaningless to an investor. While the lender will size up a property much like a serious real estate investor, concentrating on the property’s cash flow, an owner-occupant enjoys benefits such as living in the property as well as tax benefits which may justify paying a premium price.

A typical recent example involves an eight-unit, Upper West Side townhouse in contract for $4,450,000. 75% of the purchase price would be $3,337,500. However based on the actual income and expenses of the building a lender would barely be able to justify a $3,769,494 value (see chart on page 2). Even if the lender is willing to consider a blend of the sales price of the property and it’s value to an investor, the appraised value may still not exceed $4,059,747. 75% of $4,059,747 is only $3,044,810, which is $292,690 less than the mortgage amount the buyer was hoping for. Yet based on the above income and expense assumptions, ~$3,250,000 is a loan amount that would likely be comfortable for a number of lenders.

Vacancies in a prospective property present less of a problem as lenders are usually willing to attribute “market rents” to those units. Lenders generally assume that the building’s new owner will be able to fill the vacant units within a reasonable amount of time. Of course, the lender will also check public records (DHCR filings, etc.) to ensure that any vacant units are free of rent restrictions. The buyer cannot automatically presume that a vacant unit can be rented at “market value.” Over time, rents may be increased via vacancy and renovations above $2,000 and therefore become deregulated. If a unit that will be owner-occupied could be rented for, say $10,000 per month, lenders will typically include such market rents in their income calculations.

"Projected" rent rolls often make sweeping assumptions about what might happen in the future if all goes perfectly according to plan. A buyer may see huge upside potential in a given property, assuming that deals can eventually be struck with low rent-paying tenants, but a lender will be acutely aware of the risk that any rent-regulated tenant(s) may not leave.

Let’s take a very basic look at how a lender typically analyzes the cash flows in a multifamily rental property. For the sake of simplicity, let’s assume for this example that there are no stores or other commercial spaces:
Purchase Price: $4,450,000 | Proposed mortgage amount: $3,200,000 (73% of purchase price, 75% of value)

Start with the gross annual income: [$470,088]

1) Now subtract a 5% vacancy allowance from that number: [-$23,504 = $446,584]

2) Now take that result and subtract a 5% management allowance: [-$22,329 = $424,255]

3) Next subtract the actual current expenses (We’ll assume $85,000 for this example). Remember to include all other typical categories such as: RE taxes, water and sewer taxes, fuel, utilities, payroll, repairs and maintenance, legal & accounting, replacement reserves, and miscellaneous (each lender will have their own way of estimating these expenses based on their past experiences). For small buildings with 10 or fewer units, some lenders will plug in $300 or $400 per unit for management expenses rather than 5% of the income).

4) The resulting number is your net operating income (NOI). [$339,254]

5) Now plug in the annual interest and principal payments for your proposed mortgage amount with a realistic “ballpark” estimate for the interest rate and amortization schedule. As of 6/18/03, let’s assume a 4.75% rate amortizing on a 25-year schedule: [$226,478]

6) You should now be able to multiply your annual debt service by 1.25 and get a number equal to, or less than, the net income [$339,254]. If the property you are seeking to buy passes this test, then there are probably a number of lenders who will be interested in financing it for you. If your prospective purchase does not pass the test, reduce the loan amount until it does. This will give you a very realistic way to “screen” properties to see what you can comfortably afford to buy.

7) This example yields a debt service coverage ratio (DSCR) of 1.53, which is comfortably better than the minimum 1.25 coverage that most lenders would seek (Net Operating Income [NOI] = $339,254, divided by (annual debt service $222,346) = 1.53. Although the required DSCR varies according to property type and from lender to lender, it is a simple enough concept. It is essentially a “cushion” that assures the lender that even if some income is lost during the course of the loan term for some reason, the borrower will still have sufficient income to service the mortgage on the property.

Even when a building passes the DSCR test comfortably (as in this example), there are other parameters that lenders and appraisers use that may limit the loan amount, such as what capitalization rate is deemed appropriate, and whether the lender gives more weight to the income approach or to the sales approach.

There are plenty of variations on the theme of how different lenders evaluate, define valuations and establish loan amounts based on many details that are not readily apparent to the borrower. However, a conceptual understanding of how lenders approach underwriting a multifamily loan will be helpful if and when you or your client are exploring this market



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