I’m consistently surprised when brokers and borrowers ask me ‘what maximum LTV’ a lender might go to – as though the answer would tell them how much in the way of loan proceeds they can expect. It won’t.

Economic Underwriting takes precedence, which is to say: regardless of the lender’s “LTV Guidelines,” the Net Operating Income (the real NOI: with adjustments for management and reserves) divided by a Debt Coverage Ratio (1.2-1.4 depending on property type and lender sensibility) has been the traditional underwriting device that constrains how much of the NOI is allowed to be applied to debt service.

Example: after deducting all operating expenses (as well as a deduction for property management and a deduction for ‘reserves for replacements,’) you arrive at an NOI of $67,000. When that NOI is divided by a Debt Coverage Ratio of 1.25, a maximum debt service results: $53,600. If this lender offers a rate of 4.75% (on commercial property) and a 25-year amortization, the maximum loan amount possible is $783,480.92 – If the purchase price is roughly $1.3m, max leverage (by economic underwriting) is 60%

The lender well may tell you (in all sincerity) that ‘their guidelines allow for 70% LTV,’ but in the same breath are saying: very few (no) properties cash flow well enough to get there.

Mortgage brokers can soften the above blow, by sourcing lenders who offer a 30-year amortization or perhaps a slightly lower rate (although Bank to Bank, Credit Union to Credit Union, rates really don’t differ THAT substantially…) But this increases the risk for the lender because now the same NOI is dragging a bigger debt load. (happy news for the borrower seeking leverage, not for the bank seeking to mitigate risk.)

And so lending institutions have rolled out a more efficient instrument of torture: Debt Coverage.

Debt coverage is a loan sizing calculation that simply identifies the mathematical relationship between the Net Operating Income and a maximum allowable loan:

Take the above $67,000 of NOI and apply a ‘Debt Coverage’ of 9%

Max loan: $744,444. (a debt coverage requirement of 10% is of course, worse news: $670,000 max loan.)

Smaller banks and institutions aren’t yet using this a lot. Conduits, Life Insurance Companies, ‘Money Center’ Banks, etc., are.

Really understanding how the lender will assess your NOI is the key to understanding how ‘max loan proceeds’ will be determined.