Investment Properties – Loan-to-Value (LTV) Vs Debt-Credit-Ratio (DCR) And What Has Changed?

We are seeing signs that the commercial real estate market has bottomed out as users and investors cautiously begin buying value added commercial/industrial properties. However, lenders are taking a very conservative approach in underwriting these deals in today’s volatile real estate market.

Loan-to-Value (LTV) continues to play an important role in determining the loan amount and down payment required for the purchase. The appraiser plays a key role in assessing the value of the property and ultimately the loan amount. Traditionally, users/companies can expect to buy a property with as little at 10% down or a 90% LTV and investors can expect to put down 25 – 30% or a 70 – 85% LTV. This has not changed and is still the case today.

Users/Companies continue to gravitate towards SBA financing (Small Business Administration loans) which allows them to obtain a conventional loan at an 80% LTV with the SBA loaning 10% in a second position and the borrower having to put down only 10%. Obviously the company’s financials are heavily scrutinized and anyone owning more than 20% of the company must personally guarantee the loan. This has been and is still the case today.

Investors are having a much more difficult time obtaining loans to purchase income producing properties. Lenders do factor in the Loan to Value (LTV’s) on these loans as well as the investor’s financial wherewithal, but the biggest concern is with the property’s ability (income) to afford the loan payments. Debt Coverage Ratios (DCR’s) are now at the forefront in determining how much the lender will loan on the property.

In the past DCR’s were used to determine the loan amount for income producing properties but lenders were less stringent in allowing investors/borrowers to make an argument for future income (actual rents vs. market rents) in determining NOI (Net Operating Income). This, coupled with rising property value, had both appraisers and lenders being overly aggressive in projecting a property’s market value in which to base the LTV and that is what ultimately resulted in a lot of nonperforming loans you see today.

Case Study:

Earlier this year we recently represented an investment group buying an industrial building leased to a food processing company in the Vernon, California market. This is a single tenant building with a ten year NNN lease. The annual NOI (net operating income) was $141,000 with fixed rental increases every 12 months. The property was showing an 8% return based on a $1.74 million purchase price. The investment group had budgeted 25% down or 85% LTV.

The Lender analyzed the property in the following manner to determine the loan amount:

Gross Rents of $141,000
Less Vacancy of 10% or ($14,100)
Less Reserves of 3% or ($4,230)
Less Management of 3% of ($4,230)
Property Taxes to be paid by tenant
Property Insurance to be paid by tenant
Total Expenses ($22,560)
NOI was now calculated to be $118,440
A Debt Coverage Ratio (DCR) of 1.2 was applied to the NOI
Calculated Debt Service NOI / DCR = $98,700

The lender told us this property would support $98,700 or $8,225/mo in debt service. With interest rates near 6% and a 25 year amortization this translates into a loan amount of $1.27 million. When subtracted from the $1.74 million purchase price the investor can expect to put down $470,000 or 27% of the loan amount.

When the real estate market was at or near its peak in 2007, we were seeing capitalization rates (return on investment) hovering around 5.75 – 6%. It’s easy to understand why lenders had to circumvent the DCR method in calculating the loan amount in order for a property to achieve a 75% LTV:

If you take this same property at a 6% return (or $104,400 NOI) and applied the same underwriting criteria you would have the following:

Gross Rents of $104,400
Less Vacancy of 10% or ($10,440)
Less Reserves of 3% or ($3,132)
Less Management of 3% of ($3,132)
Property Taxes to be paid by tenant
Property Insurance to be paid by tenant
Total Expenses ($16,704)
NOI was now calculated to be $87,696
A Debt Coverage Ratio (DCR) of 1.2 was applied to the NOI
Calculated Debt Service NOI / DCR = $73,080

At $73,080 (or $6,090/mo) in debt service based on a 6% return and a loan amortized over 25 years, it equates to a $945,209 loan amount. This would require the investor to put down $794,790 which is a 46% LTV.

In this instance, investors were unwilling to put 46% down and would make the argument that in the near future the $118,440 NOI (as stated above) was achievable. Lenders wanting to make the loan would buy into this argument allowing in part the DCR to be applied to the increased rents. The appraisal report would support this amount by using comparable sales to users, not investors to support an 85% LTV. Lenders would make the loan with an investor allowing them to only put 25% down when in reality they should have put 46% down as stated above. As lease rates and property values continued to plummet, these same properties no longer cash-flowed. With only 25% invested in a property that lost as much as 50% of its value we can see why so many investors walked away from their loan commitments.

Property Investment in Calabria – The Emergence of Southern Italy

Located at the southernmost tip of Italy’s boot, and surrounded by the azure waters of the Tyrrhenian, the Mediterranean and the Ionian Seas lies the beautiful region of Calabria. Widely tipped as being an investment hotspot, the relatively undeveloped and rugged Calabria has seen increasing amounts of investment activity in recent times. Stretching from the Reggio Di Calabria region in the south, through to Cosenza in the north, Calabria is an intoxicating blend of mountainous scenery, beautiful valleys and picturesque coastal regions.

Calabria has seen considerable increases in tourism in recent years, as large number of cheap flights have opened up from major European hubs including the major markets of Germany and the UK. Attracted by the superb climate and stunning natural beauty of the region, Calabria experienced an increase of over 23% in tourism in 2007, a figure which is expected to increase in the coming years.

Throughout the Calabria region, a wide variety of activities are available including skiing, scuba diving, hiking, fishing and golf. In fact, the region is one of the few places where it is possible to go skiing in the morning, and still sunbath in the sunshine in the beach later in the day!

Whilst the natural beauty of the region, coupled with the superb climate and wide array of activities may well present a strong argument for people to consider investing in property in Calabria, there are a number of equally compelling monetary arguments for investing it the region.

Traditionally, the south of Italy has been considered a poor relative to the more affluent major cities further north in the country. Recently however, over EUR100 billion in investment has been pledged to the south of Italy from the EU and Italian government. Already the benefits of this huge investment in the region are coming to fruition, and structural improvements to the local autostrada and regional airports are increasing accessibility and subsequently tourism to the region.

Equally appealing to potential investors is the low prices of property in Calabria, which despite the fact that real estate in the region is beginning to rise, is still considerably cheaper than elsewhere in the country. Last year saw the price of property in Calabria increase by over 20%, and current estimates are suggesting capital growth of around 20-25% per annum over the next five years.

Finally, the legislation in the region affords investors substantial potential long term savings. Inheritance tax was abolished in 2001, and this coupled with the fact that there is no capital gains tax after a five year period, ensures that property investment in Calabria provides the potential for substantial long term returns.

The Arguments for LLP Formation

In the UK, like anywhere else in the world, forming a working partnership doesn’t require formal documentation, although it’s advisable to do so. In case of any untoward and unexpected incidents, it’s best to have everything written down and legal, to avoid any questions that might arise. When two or more people come together for financial or business purposes, they could be considered a partnership. It’s of a long term nature and one that may continue until dissolved or a partner dies.

A partnership agreement is actually not necessary since these automatically fall under Partnership Act 1890. This governs a partner’s basic rights such as the share of profits and losses and the manner in how the business ought to be conducted. With three types of partnerships recognized, the kind of partnership entered into by the investors is crucial. First is the General Partnership, one that is formed with or without documentation.The partners operate as one, as to taxation, profits, and losses. The partners are jointly and severally liable,meaning that each one or just one may have to absorb any losses incurred by the business. The LLP, or Limited Liability Partnership, is more commonly chosen as each one is responsible only for his own debt however the partnership is still taxed as one entity. A Limited Partnership is a hybrid of both. A limited partner is liable only for what he has invested while his general partner must answer for everything else. It’s still taxed as a single entity.

That is why LLP formation is recommended both legally and fiscally. It’s a safeguard to all investors, especially the minor ones who may be held responsible for debts not incurred by them and impossible to pay! This must be handled by a competent solicitor. A comprehensive LLP Formation Document is one that covers all aspects of a business, not just its financial side. Everything from basic daily management and meetings to partnership duties and powers of attorney to loans and reimbursements should be covered. A special section should be devoted to new members entering into the business, members retiring or simply leaving the partnership, and termination of staff or of members themselves in case of misconduct.