Every lender has a different perspective on the world, even if debt seems like a commodity. They each establish the loan amount and cost based on that world-view. This is known in the industry as sizing debt and pricing.
The debt market is very competitive. Therefore, most lenders tend to be price takers in their respective niche. Interest rates are set by a competitive market process, as a result.
Let’s consider the more critical piece for you. How should you go about sizing your debt?
Loan-to-Value (LTV)
Most investors start and finish with loan-to-value (LTV) or loan-to-cost (LTC). It’s straightforward and understandable.
Debt sizing with this method starts with establishing your base. You may determine real estate property value with various methods.
An acquisition loan will lean heavily on your purchase price and additional costs (cost basis) relative to comparable sales. Stabilized properties with conventional financing will use today’s value exclusively, while value-add projects with project debt rely on a cost basis.
Refinances use the same methodology at the time of execution. However, cap. rate is the most effective way to establish value in a forward-looking model (pro forma).
In the cap. rate method, you simply divide the projected net operating income (NOI) by an expected cap. rate to determine value. Once you have that value, simply benchmark against today’s comps to determine feasibility.
The loan amount is easy after you have the base – value or cost. Simply, multiply that base by your LTV/LTC. For example, a loan amount for a $10 million project at 70% LTC would be $7 million ($10 million * 70% = $7 million).
Debt Yield (DY)
Debt yield tells the lender her return on investment in case the project fails. Think of it as the lender’s cap. rate.
Debt Yield = Net Operating Income / Loan Amount
As you can see, a simple adjustment on the debt yield equation will produce a loan amount based on the target debt yield.
Loan Amount = Net Operating Income / Debt Yield
The target DY depends on your project’s risk level and projected cash flow improvement. Stabilized properties usually target 10% or above. However, project loans will target a low entry point with increasing debt yield targets to qualify for loan extensions.
Here’s an example. The lender may size your project loan based on a 70% LTC, but the debt covenants may have debt yield tests following substantial completion of the project. In this case, you will look out to years 2 and 3 to test if the loan amount still works for your project.
In this way, debt Yield is also an important check when sizing a refinance in a pro forma analysis.
Debt Service Coverage Ratio (DSCR)
The final lender credit metric that you should consider is how your free cash flow covers annual debt service. The lender wants to know that they get paid AND you have some to keep for a healthy balance.
Debt Service Coverage Ratio = Net Operating Income / Debt Service
Like debt yield, this measure is more relevant out the gate for stabilized properties. Value add projects will measure the debt service coverage ratio in the forecasted years.
Healthy DSCRs start at 1.20, which shows a 20% buffer between NOI and debt service. You can look at that number as a margin of safety or profit. Regardless, that should be your minimum when considering a stabilized operation.
You need a few more data points to size debt on this measure – interest rate, amortization term, and NOI.
The calculation is relatively easy for an interest-only loan. Divide the NOI by your target DSCR, then divide the result by the interest rate. For example,
- Debt Service = $1 million NOI / 1.25 DSCR = $800,000
- Loan Amount = $800,000 Debt Service / 5.0% Interest Rate = $16 million
Fully amortizing loans are a bit trickier. You need to use a financial calculator or spreadsheet. The process is very similar, though. Take the debt service amount at your target DSCR and combine it with the interest rate and amortization term to get the loan amount. The PV function in Excel will get you to your result.
Loan Amount = PV(Interest Rate / 12, Amortization Term * 12, Target Debt Service / 12)
Debt Sizing Reconciliation
Sizing your debt is easy once you have the three results above. Your maximum loan amount is the lowest calculated result.
Wait… what?
Each calculation method provides a result where the lender will feel comfortable. Therefore, your loan would trigger a technical default on the other credit metrics if you were to choose the highest loan amount.
The loan-to-value method typically drives while the others navigate.
I like to use debt yield in pro forma analysis to determine the refinance loan amount. It is an objective measure that can’t be manipulated by an arbitrary cap. rate or interest rate assumptions. Beyond that, I encourage you to play around with each one to get comfortable with the process.