How Lenders Calculate Apartment Loans
The article details how a lender detemines the size of loan an apartment building of 5 units or more, can qualify for. Loan sizes for rental properties of 1-4 units are based on loan-to-value percentages, but properties with five or more units undergo a line-by-line analysis of income and expense. The method and procedure are explained, to familiarize borrowers and their advisers.
The object of this article is to help the investor have a more successful experience with the loan industry, by becoming familiar with how underwriters calculate how much can be lent on a particular apartment property. Additionally, the article seeks to help the interested investor arrange his/her management practices to be a more consistently successful borrower by presenting usable cash flow information to a lender. Finally, owners can use these concepts to make their apartment properties more salable when that time comes, by maintaining better practices and records.
There is a substantial difference between how an apartment building owner or buyer calculates loans, compared with how lenders do it. Frequently, I am asked how high of a loan-to-value I can lend on an apartment property. The answer comes with explanation. I can lend up to 80% LTV in an eligible situation, provided (among other criteria) the property has enough cash flow for that size of a loan. What does that mean?
In order for a building to qualify for a loan, it has to demonstrate that it can make the payments itself without relying on the building owner’s pocket book or other properties. So, the loan underwriter needs to understand the cash flow of the building, and from that will calculate how much of a loan the property can pay for on its own. It’s this calculation based on cash flow, not a simple percentage of purchase price or appraised value, that determines the amount of the loan.
The cash flow of a property is actually called the Net Operating Income, or NOI. NOI is the amount of cash flow remaining after the expenses are deducted from the gross annual rental revenue, and is figured on an annual (not monthly) basis. Actually, that should really read eligible gross annual rental revenue, because not all dollars coming in the door can be counted as gross rental revenue. Perhaps a chart will help clear this up:
Eligible As Gross Rental Revenue
- Basic monthly rent
- Additional rent for pets
- Rent collected for a garage or carport space
- Rent collected for additional storage space
- Utility Reimbursements
- Additional rent for additional occupants
- Charges for cable, WIFI, internet
Ineligible As Gross Rental Revenue (Can’t count these dollars as revenue)
- New tenant security deposits
- Application fees
- NSF check fees
- Credit checking fees
- Late payment fees
- Damage reimbursements (Offsets extraordinary maintenance/repair expense; should be a wash.)
- Insurance settlements
Thus, the loan officer will ask for the actual rent roll on a proper rent roll form, not just the reported gross rental amount. This is one reason why the listing real estate agent’s offering memorandum is not sufficient for calculating a loan; the underwriter must see the origin of the dollars reported as gross rental revenue to document that the dollars are eligible.
Once the amount of annual eligible gross rental revenue dollars is established, the expenses can be measured and deducted to determine NOI. The underwriter usually figures expenses higher than what many owners or buyers do, because underwriter needs to figure out how much it will cost for the lender to operate the property in the event the property comes back as a result of foreclosure. Let’s list some expenses and see how this works.
Expense Item, how calculated, and commentary
Vacancy; 5%; In regular times, 5% is used as a vacancy factor. In some parts of the country, normal vacancy rates are more than 5%, in which case the market figure is used. Gross rental revenue less the vacancy factor dollars is called the Effective Gross Rental Revenue. This is an important term, and is worth becoming familiar with.
Property Tax; Tax rate times loan amount; If lender ends up owning the property due to foreclosure, its cost basis will be the remaining balance of the loan. The tax rate will be applied to that loan amount, and the higher of the resulting figure or actual tax will be used. In some instances in certain tax jurisdictions, taxes are being lowered for the following year. Underwriter will use the lower figure if we can document it with something in writing from the taxing authority.
Licenses & Legal Expense; $50 per unit per year; Annual business licenses, reserve for legal service for legal service when needed. If actual such expenses are higher than $50 per unit per year, the higher figure will be used. High turn-over properties may have higher legal expenses, especially if eviction service is used regularly. So, it's best to choose nice tenants who pay their rent on time.
Insurance; Historical premium expense; It's important to ensure that all necessary coverages are included, as we often find that properties are under-insured. One 15-unit property had residential homeowner's insurance on it rather than commercial insurance. Had there been a loss, the insurance company may legitimately have declined the claim. We sometimes find historical insurance premiums unusually high, in which case we will urge an insurance re-quote.
Natural gas, Electricity, Water, Sewer, Cable, Scavenger (trash);Historical + 3% Please keep records of these bills, even if digital to prevent paper clutter. Occasionally, we need to document these amounts to support a higher loan amount.
When it comes to utilities, the loan officer or analyst needs to know which ones the landlord pays, and which ones the tenants pays. It is common for the landlord to pay for hot and cold water, and sometimes for electricity. But, sometimes all utilities are individually metered so that the tenant pays for all utilities including water. This would reduce expenses, justifying a higher loan amount than if landlord was paying for water and perhaps for electricity.
Gardner, Swimming Pool, Elevator: Historical cost of maintenance. With luck, these costs have been similar year-to-year, though costs can vary up and down from one year to the next. It's necessary for analyst to understand why and by how much so as to accurately forecast what the costs will likely be during the years the loan will be in place.
It's common for an owner to want to leave gardening, pool, and some other items out of the cost structure, arguing that he or a family member takes care of those items at no cost. When so, lender will still include the market rate of contracting those functions. If the unexpected happens and lender has to operate the property, those items will have to be contracted out.
Off-Site Management:4%-5% of Effective Gross Revenue. Again, though the borrower may well be self-managing the property, lender could possibly find itself having to do so. The cost of hiring good professional management is provided for. If the borrower is a first time buyer, or if borrower is from out of town, local professional management will be necessary anyway.
On-site Property Manager: $45.00 per unit per month, times 12 months. Some states require an on-site manager if there are more than a certain number of apartments, say 16. If the owner lives in one of the apartments and self-manages, this allowance is still taken because if the property becomes an REO due to a foreclosure, lender will have to hire a replacement.
An on-site manager may be compensated with reduced rent or a free apartment, which is fine. For underwriting purposes, regular rent is recognized for the apartment and the dollar value of the reduced or free rent is included in the $45.00 per unit per month.
Payroll: Historical payroll plus benefits and employment costs, adjusted for reasonableness. If a property is big enough to have full-time maintenance and leasing staff, their pay and benefits have to be included. If the amount of payroll makes sense for the task, historical figures plus an inflation escalator will be used, as there may be pay increases necessary to keep good people.
Repairs and Maintenance:$300 per unit per year per year. This allowance is made whether last year’s bills added up to this much or not. If the money wasn’t needed this year, it likely will be next year. If the property is old or has deferred maintenance, this figure could go to $350.00 or more. If it is brand new or if it was just extensively rehabilitated, the figure could be $250.00 per unit per year. It's a judgement call.
Care needs to be taken that this expense does not include a new roof, installation of new kitchens or appliances or bathrooms as these are items of capital expense rather than repairs and maintenance. If repair and maintenance expense appears high in relation to the property, owner will be asked to complete a capital improvements schedule to separate out the extraordinary major replacement costs and leave only the day-to-day or month-to-month maintenance costs.
A reasonable figure is used for landscape maintenance. Some properties have no green at all, and thus have no such expense. Others have extensive gardens and such, and the historical expenses are used.
Supplies: $50 per unit per year. This covers bottles of soap, scrub brushes, minor hardware; small stuff vended by the home improvement center and hardware store. Allowance is made whether it’s being spent or not, because it should be for a well-maintained property.
Painting and Decorating:$75.00 per unit per year. This amount is budgeted for keeping the trim painted and the outside of the windows clean. The idea is to budget so that the property always looks attractive and appealing. Ideally, the building will sit there and entice tenants with its serene beauty, thus keeping it rented. Such is the basis for investor appeal, which underwriters want properties to have.
Cleaning: $75.00 per unit per year. This allowance is for cleaning and painting an apartment when a tenant moves out. Any vacancy has to be made rent-ready within days of a move-out. Sometimes, properties are presented with vacant units that have not been made rent-ready because the money that should have been set aside for such got spent on something else in the owner's life. A request for a refinance of such a property will be difficult to honor, as underwriters don't want to lend into such situations. This presents a profound problem when the existing loan is coming due, and cannot be refinanced. Does this actually happen? Yes.
Office and Telephone:On small buildings with no rental office, this expense is dispensed with. But, if the property has a rental office, this expense is measured and accounted for. If one of the apartments is used as an office, and if it has not be expensively modified for office use then the market rent it could be getting (but isn't) is still included in gross rental revenue. Add telephone, internet, and other expenses that there may be (bottled water delivery, for example) for the total figure.
Advertising: $15-25 per unit per year: Even if the building is chock full of tenants, advertising allowance will be provided to ensure there is the where-with-all to keep it full. If the building has been kept full through the use of Craig's List or other free service, and there has been no advertising expense, a case can be made for this. Loan amount may increase a little.
Snow Removal: Historical. One never knows how much snow will come. There needs to be a reasonable provision. If this expense is low this year, expect it to be grossed up for next year.
Reserves for Building, appliances, carpets & window covers, plumbing fixtures, kitchens and bathrooms, parking lot, exterior paint: $200-350 per unit per year depending on the age and condition of the property. These are dollars (supposedly) set aside from the regular cash flow of the property for the eventual replacement of these items and other big jobs called capital expenditures. Things wear out or deteriorate with age and normal use, then must be replaced. There need to be funds available to pay as those items come due.
A few lenders will actually require one twelfth of the annual reserve budget be paid each month in addition to principal and interest. The reserve dollars are stored in an impound account so that there is always money to keep the building in tip-top condition so as to attract tenants and, someday, a new lender or buyer. Not all lenders don’t require this impound, but all will still budget for it, hopeful that the borrower is squirreling away the funds in a cookie jar for when building components need replacement. (Ha!)
The appraiser will research and report what the typical market expenses are for Subject property, and the underwriter will rely heavily on the appraiser's numbers. The initial analysis and underwriting will be to forecast and predict the appraiser's figures. The object of the effort is to reasonablely ensure that the loan amount that results is acceptable to the borrower before an expensive appraisal is ordered with his money.
A few additional notes about expenses:
#1) Owners who employ on-site management often compensate the manager with discounted or free rent. Since that apartment could readily be rented to a non-discounted tenant, that apartment is included in gross annual rent calculation at full market rent. The amount of rent discount is taken as a portion of on-site manager expense.
2) If an apartment is used as a rental office, the market-rent it could bring can be included in gross rental revenue as long as no major modifications are needed to make it rent-ready. If walls would have to be moved or other major modifications needed, it could not be included in gross rental income.
3) Some buildings have rents below market, and borrowers ask a lender to lend on the basis of market rents rather than the lower actual rents. Some lenders used to do that when the loan was for a purchase, but not any more. Actual rents are used now, less any rent concessions. Many purchase loans and refinancings have been frustrated by rents below market. Some owners acknowledge that they keep the rents low to keep the property rented. Sometimes, a tenant has not had a rent increase since moving in 25 years ago, and is paying rent of $250.00 per month when market rent for that apartment is $850.00. The argument is that the owner is simply trying to reward tenant loyalty. As sweet as that is, the existing rent in place will be used to calculate the loan amount and it often comes up short of the needed loan amount. Thus, it’s important for owners to keep rents at market level (not above market, as when rents are higher than market, the lower market rents are used).
Once all the annual gross rental revenue numbers and the expense numbers are gathered, the annual expenses are deducted from annual gross rental revenue to find NOI. If annual gross rents total $500,000 and expenses total $200,000 including vacancy alowance, that will leave $300,000 as NOI. If the expenses are not at least 35-40% of annual gross revenue, the situation will have to be reworked. Expenses ratios that are too low suggest that the building is not being maintained adequately.
The $300,000 NOI is available for making loan payments. Almost. The lender will need to see that the property is generating $1.25 (or more) for each $1.00 of principal and interest payments that are to be paid. This is a debt service coverage ratio (DCR) of 1.25, which is a common DCR figure for apartments. So, the $300,000 will be divided by 1.25, yielding $240,000 available for principal and interest payments. The $240,000 is divided by 12 months, yielding monthly payments of $20,000, and that’s how much of a monthly principal and interest payment the property can pay.
The underwriter will calculate the loan amount by using a computer program or a hand-held financial calculator. He/she will enter 360 payments of $20,000 each at an interest rate, perhaps, and the software will report a loan amount. Some lenders (not all) use a higher interest rate for calculating the loan amount than the actual note rate. Using a higher rate tends to limit the resulting loan amount, providing an extra margin of safely. If the note rate is 3.50% but Lender uses an underwriting rate of 5.50%, the calculation will result in a lower loan amount than if Lender used 3.50%. At 5.50%, 360 payments of $20,000 each will result in a loan of $3,522,435.
If the purchase price (supported by the appraisal) is $5,500,000, the loan-to-value ratio will be 64%. If the purchase price is $4,000,000, the LTV will be 88%, except that the maximum LTV for the loan program is 80%. For other loan programs, 75% is the limit and for some, it's 65%.
One big difficulty in lending is that some owners and sellers don’t keep good records (Many thanks to those who do!). For a property to qualify for today’s 80% LTV loan, the loan officer will ask for the last 12 months of monthly income-expense statements (called a trailing 12 report).
One loan I recently tried to do fell apart because the seller had included the income and expenses with those of several other properties he owned. I needed the revenues and expenses of the subject property presented separately to do the loan. Seller could not do that, and his accountant had lumped all the expenses of several properties on to the Subject property as he found that easier than detailing each one. Also, he had not watched the property and had a person managing it who had been distracted by other areas of life. The property had had two vacancies for a long time, and one tenant had been allowed to pay half rent for a long period. For this particular agency loan, the property has to have 90% occupancy for 90 days or more, and the seller did not keep sufficient records to show that. So, his sale fell through.
generally, loans require two to three years history of stabilized operation. Year-end income and expense information for the past two or three years would have to be presented, along with year-to-date income and expenses for the current year and a current rent roll.
This overview is hopefully useful to investors and their personal advisors. There are variations to this theme, depending on what loan is being contemplated. A loan insured by the FHA will have unique underwriting, and there will be differences if a property is all Section 8 subsidized rent. Fannie Mae and Freddie Mac loans have other unique underwriting rules. Conventional non-agency loans have still other criteria. All are aimed more at keeping depositors' dollars safe and protecting tax payers from defaulted loans, than at pleasing a loan customer. Fancy that; it's difficult to treat the borrower is #1, even though it's him/her who makes it possible for us in the loan industry to earn a living.
Just because an investor has the ability and desire to purchase investment real estate, that doesn't mean that he/she has the ability or interest to keep the records and mind the business aspect. An investor who doesn't happen to thrill over managing records and papers is advised to hire it done in order to keep a property financeable for either refinance or sale.
Earl A. McCoubrey California DRE # 01747620
Commercial Real Estate Loan Officer
Winston Rowe on September 04, 2016:
Very informative, I really enjoyed the article. It will be helpful for me in the future. Great post.