Commercial Mortgage 101

Commercial Mortgage 101: Overview

We have gathered some tools and resources that will help you with your investments the most important value you can bring to a transaction is your knowledge and expertise. If you have a good understanding of the investment metrics used to value income property, you will have tremendous credibility in the transaction. Commercial real estate is numbers-intensive and relationship-rich, so if you want to succeed, then learn to do it the right way.

Learn more about the formulas and ratios that lenders and investors use to value property. We have created a brief tutorial for each concept, explaining why it’s important, how to calculate it, and some real world examples:

Capitalization Rate:

Overview: When buyers and agents ask you what is the cap rate for a listing, they are referring to the capitalization rate, which is a common ratio used to evaluate the investment return for income-producing properties. Cap rates can vary greatly depending on property type, collateral quality, market area, and availability of financing. A property’s cap rate can also indicate a perceived immediate upside or downside to the investment, depending on whether it is in line with the prevailing cap rates for similar properties in its market area.

Debt Coverage Ratio:

Overview: While investors ask about cap rates and gross rent multipliers to determine whether or not a property meets their investment criteria, lenders tend to focus on something called the debt coverage ratio (DCR). You may not be as familiar with this metric, but you can bet that your lender or mortgage broker is intimately familiar with it because the DCR can determine financing options for a property.

Debt-to-Income Ratio:

Overview: When considering a loan request, lenders use different ratios to determine creditworthiness for a borrower. Even though commercial real estate financing relies heavily on the property’s net operating income to underwrite the loan, borrowers are viewed as a secondary source of repayment for the loan in case anything should interrupt the cash flow from the property. Besides examining a borrower’s credit history, net worth, and liquid assets, a lender will also consider the borrower’s debt-to-income ratio.

Gross Rent Multiplier:

Overview: Most old-school investors use a simple rule-of-thumb to estimate a property’s value, and this is known as the gross rent multiplier (GRM). The reason for its popularity is that it’s so easy to calculate. Unfortunately, it does not always offer the most accurate or reliable method of estimating the market value for a property. For example, the GRM does not consider such fundamental investment criteria as cost of capital or even operating expenses. Despite its drawbacks, the GRM is a tool that can provide a “quick and dirty” comparison to similar properties in the area.

Loan-to-Value Ratio:

Overview: Most investors believe that the maximum loan-to-value ratio (LTV) offered by a lender applies to every single property, regardless of net operating income or debt coverage ratio. This is hardly the case, as properties in Southern California rarely achieve the maximum LTV offered by a lender due to high property values and strict DCR requirements. LTV is closely tied to an important concept, which is leverage, and most investors understand that higher leverage can result in less cash flow; since a greater portion of the property’s net operating income is being used to make the mortgage payments.

Net Operating Income:

Overview: Investors don’t usually decide to buy properties based on “curb appeal” or aesthetics more likely, they buy the income stream from the property. Commercial real estate value is based on numbers and ratios, and the most important number to know is the net operating income for a property. The net operating income (NOI) is the single most important number used to determine value and financing options.

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