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Loan-To- Value Ratio And Debt Service Coverage Ratio: Two Things You Should Understand Before Lending Or Borrowing For A Real Estate Project

Loan-To- Value Ratio And Debt Service Coverage Ratio: Two Things You Should Understand Before Lending Or Borrowing For A Real Estate Project

Real estate development is more than just constructing a building. It is a complex process that embodies a series of efforts and activities geared towards attaining a goal. The term ‘Real Estate development’ itself has been described as the process of financing the acquisition of land with the intention of developing a building for leasing or sale in the end. Thus, it starts at the time you conceive the project idea and ends when it is completed and leased or sold (Miles et.al, 2015).

Irrespective of how ambitious you are as a developer or investor, there is one key ingredient that is needed to spice the project up and make it a reality. While several resources and activities ranging from site acquisition, designing, permitting, contracting, construction among others are very essential, finance is the most important factor. Others may have varying views to this but it is something that cannot be disputed. Without the required funds, every project will be redundant. The availability and adequacy of finance determines the quality of a project and its finish time.

Finance for a real estate project can come from two main sources (equity and debt). Equity financing is when the project owner(s) stump up the entire funds needed for the project from design stage to completion. The second form of finance is debt finance where funds are borrowed towards the project. This in real estate is often referred to as leverage. This article is not for the equity minded real estate developer but one who wants to use leverage.

There are many people who do not know that sometimes even when you have equity, using leverage is good and there are others who know this but the choice of debt asset they go in for in a project may result in negative perceptions about the use of debt in the future. In a typical real estate project in the developed world, the investor or developer who wants to use debt will go for a kind of loan facility we call ‘mortgage’.

A mortgage is a loan that is backed my real property as collateral. In simple terms, it is a loan you are granted for a project and you use the project to secure the loan such that when you default in paying, the lender can take the property and sell it to recover the debt. I don’t want to go into the details of mortgage types and the conditions they come with but in any case, or mortgage scenario, the loan is expected to be secured by real property.

There are other arrangements where a promissory note or ‘I owe you’ kind of agreement can be incorporated into the mortgage transaction such that when there is a default in the mortgage repayment and the building is below the value of the outstanding mortgage balance or is non-existent due to a natural disaster, the lender can recover the debt from other assets of the borrower. This option is riskier for the borrower and may discourage borrowing and in effect cripple the financial markets for real estate. But let’s assume that there is an active mortgage market where lenders are willing to part with funds towards projects for some return in the form of interest. With this scenario, both parties (lenders and borrowers) cannot just run into the transaction with a herd-like attitude. They need feasibility studies.

While the former will be interested in knowing that the project, they are about to finance can generate the cashflows needed to pay their funds and interest back, the latter wants to know that the intended mortgage can be repaid and the developer’s profit targeted can be achieved as well.

Let me state that there is no developer who will deliberately want to default in a mortgage repayment and there is no lender that will fund a project when they know it will be unprofitable. The reality is these sometimes happen unexpectedly but sometimes feasibility analysis can help one see tomorrow from today. Two feasibility analysis that lenders use and borrowers need to understand are the (1) Loan to Value- Ration analysis (LTV-R) and (2) Debt Service Coverage- Ratio analysis (DSC-R). Let’s discuss these further in the section below.

LTV-R

The LTV-R is the percentage of the project value or cost that a lender is willing to grant as a mortgage (Geltner and Miller, 2001). In simple terms, when you apply for a loan for any project, the lender is often not going to grant you the exact amount you requested for. Even in personal loans, they will usually request for your pay slip and use that to decide how much to grant to you. This is because the lender wants to be sure that the loan you are being granted can be paid off by your salary. The same principle works in mortgage finance.

The LTV-R is essentially a mathematics that converts the value of your intended project/ cost into the maximum mortgage amount it can support. No rational lender will grant a borrower 100% of the loan amount being requested except in an environment where property values are always high and some form of super normal profit is possible. Even with this, the risk of unforeseen events such as political instability, market conditions and natural disasters must still be considered.

The point am trying to make is the lenders will often want to grant you what they think is appropriate per their terms and that is pre-determined using the LTV-R.  For example, if Miss Abena- P intends to build an ultra-modern student housing in Accra and estimates that the value of the project at completion will be Gh¢ 5,000,000 and she applies to First National Bank (FNB) for a mortgage, the bank will have a pre-determined LTV-R. Let’s assume that the lenders LTV-R in this case is 75%, it means Miss Abena-P will only get a maximum of seventy-five percent of the Gh¢ 5,000,000.

This will mean that she will be granted a mortgage worth Gh¢ 3,750,000 (75 percent of Gh¢ 5,000,000). What this means for the lender is that the 25% of the expected project value is a cushion against default. For instance, it is expected that a fall in cashflows or market value will not just plummet and will take a period of time. If the lender grants less than Gh¢ 5,000,000 as we saw in our example, it means that if all the rents expected are not generated in any academic year, the bank may still get its money from what is generated. While the LTV-R helps the lender to get a cushion towards default and potential loss of its investment, what does it mean for the borrower?  In the case we saw, an idea of the LTV-R though mainly a lender’s perspective variable, helps Miss Abena-p to know how much equity to invest in the project or other sources of finance to look out for.

 A smart borrower can also use knowledge of a lenders pre-determined LTV-R to decide how much to apply for in order to obtain a targeted mortgage amount. For instance, Miss Abena-p having in mind that she requires Gh¢ 5,000,000 and the lenders LTV-R is 75% may put in an application for Gh¢ 6,666,666 so that when the LTV-R of 75% is applied to it, the Gh¢ 5000000 can be obtained. Of course, the lender will decide if the value of the project is actually worth the amount but certain factors such as good credit history, Industry experience of the borrower, location of the project and type of project among others may let the borrower get away with the over valuation.

DSC-R

Unlike the LTV-R, DSC-R is a measure of the actual cashflows to be obtained from the completed project to service the mortgage. In simple terms, lenders use it to determine whether the income that will be left periodically after operating expenses are taken will still be enough to pay their money back to them. Again, the lender wants a cushion against any default and loss of their investment. It is calculated as Net Operating Income (NOI) divided by Debt Service. This can be simplified mathematically as NOI/ DS. The debt service is the periodic payment of the loan. This can be monthly, quarterly, semi-annually or annually depending on the lender’s terms.

The NOI is the income that is left after all operating expenses are deducted. For instance, after taking rent from tenants, there are operating expenses such as waste collection, water bills, electricity bills, repairs’ etc that the landlord may incur each month. Thus, the monthly NOI will be the difference between the total rents and the expenses incurred. Let’s get back to DSC-R and see how it works. Let’s use the previous example involving Miss Abena-P’s project.

Let’s assume that FNB is willing to grant 75 % of the expected project value of Gh¢ 5,000,000  it means they are willing to part with Gh¢ 3, 750,000. Let’s assume they are granting the mortgage at an interest rate (i) of 15% (0.15) per annum for 10 years and the loan is to be paid monthly. This means we will have a monthly interest rate of 1.25% or 0.0125 (0.15/12). We are dividing by 12 because there are 12 months in a year so any loan in annual terms that must be paid monthly must have the annual interest rate divided by 12 to convert it to monthly terms. The number of periodic payments(n) must also be converted from annual to monthly. In this case we will find the number of months in 10 years as 10x12 and that gives us 120 months. We can compute Debt Service (DS) as

Where I= monthly interest rate; n = number of months.

Thus, the DS in Miss Abena-P’s case using this formula in Microsoft excel (may be slightly different when manually done) will be Gh¢ 60,501 per month. Let’s assume that each month, the NOI from the rents to the project owner will be Gh¢ 80,000. Then the DSC-R will be 1.32.  Don’t forget the DSC-R is computed as NOI divided by DS. This 1.32 is same as 132% (1.32 x100)

What the DSC-R of 132% means is that the NOI from the project in each month is 32% more than the lender will be owed. In other words, after paying off the mortgage in each month, the borrower will still have 32% of the Gh¢ 60,501 left as profits or personal income from the NOI. For example, the difference between the Gh¢ 80,000 (NOI) and the Gh¢ 60,501 (DS) is Gh¢ 19, 449. This figure is actually 32% of the DS computed.

In any transaction, lenders will only have a cushion when they go for a DSC-R above 1.0. A DSC-R of 1.0 (100%) means that the DS is same as the NOI that the property can generate, thus any drop in the NOI due to a fall in cashflows will mean the borrower cannot service the mortgage(default). Thus, a DSC-R of 1 0r 100% means the lender is sitting on the fence and can fall to either side of it. To avoid this uncertainty, they will always provide an amount that the DSC-R will be greater than 1.0

 

Conclusion

The LTV-R and DSC-R are both often used together. The former helps the lender to decide the how much to grant at a first instance based on what they think the value of the project will be or the cost that will be involved in realising the project but the DSC-R is used to determine the ability of the property after it is completed to generate the needed cashflows to pay the loan. In essence, it helps the lender to make a final decision to grant or reject the application. It also helps the borrower to know how much returns to expect. It also helps the borrower to decide on the best mortgage option. For instance, in the example we had, a loan with lower interest rate or more years above 10 will result in lower DS and the borrower may choose that option.

References.

Geltner, D. and Norman G. M., (2001). Commercial Real Estate Analysis and Investments. South-Western, Thompson Learning.

Mike E. Miles, Gayle Berens and Mark A. Weiss (2015). Real Estate Development: Principles and Process, fifth edition. Urban Land Institute.

 

Author: Oliver Tannor

The Author is an Assistant Lecturer, Department of Real Estate & Land Management, SD-DOMBO University of Business and Integrated Development Studies.

He is a Real Estate Consultant & Researcher and founder of Maxson Realty.

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