Seven Ratios of Commercial Loan Underwriting
Much of commercial loan underwriting can be boiled down to just seven financial ratios:
- Debt Ratio: This is the ratio that makes sure that the borrower is not overwhelmed with personal debt. Does his house payment exceed 25% of his gross income? When you add in his car payments, credit card payments, and student loan payments, is the borrower spending more than 33% to 35% of his gross income?
- Loan-to-Value Ratio: This is the ratio that makes sure that the collateral - a piece of commercial property - is worth materially more than the amount of the loan.
- Debt Service Coverage Ratio: This is the ratio that makes sure that the property alone is generating more than enough net rental income to cover the proposed payments on the new loan, plus a required amount of cushion.
- Debt Yield Ratio: This is a brand new ratio used mainly by the conduits (CMBS lenders). Don’t confuse it with either the Debt Ratio or the Debt Service Coverage Ratio. This ratio makes sure that if the lender forecloses on Day 1, the property is generating enough net operating income (NOI) to give the lender a target yield of, say, 9% or 10%.
- Net-Worth-To-Loan-Size Ratio: This ratio makes sure that the borrower is wealthy enough for the amount of the loan in question. A bank certainly doesn’t want to make a $10 million loan to a borrower with a net worth of just $250,000.
- Loan-to-Cost Ratio: This ratio is used in construction lending. This ratio makes sure that the developer has some skin the game and that the bank is not taking all of the risk.
- Profit Ratio: This ratio is also used in construction lending. The purpose of this ratio is to make sure that the developer stands to make enough of a profit that he won’t simply bail if he has a few cost overruns.
We discuss each of these ratios in more detail on the pages indicated with a hyperlink.