A business always needs to do their homework before embarking on a project necessitating large sums of money and debt and that involves construction. With so many moving pieces, you’ll need to know what is expected before working with a bank, so you can position your startup to the best possible advantage. This post will go over everything you need to know to underwrite real estate risk.
What Is Needed To Underwrite Your Real Estate Risk
Your lender will initially schedule a meeting with you where you’ll discuss interest rates, loan policies, and your financial information. You will need to meet your institution’s qualifications on seven different ratios, and we will discuss these below.
Your debt ratio is a figure that shows your lender that you won’t be overwhelmed with debt. It demonstrates a healthy ability to make your payments, and typically, the payment for this new loan should not be greater than 25% of your total income. In addition, all existing lines of credit should not account for more than 33-35% of all revenue, leaving plenty of room for contingencies.
Up for consideration will be the loan to value ratio, and this is a sum that helps your bank determine that your collateral is valued at a higher value than the amount being financed. This ensures that the lender will be able to recover their expenses in the event that you are unable to pay the note, as they will acquire your property.
Also, an important piece of information is the debt service coverage ratio, a statistic that shows the bank that your prospective rent payments are able to cover your required payments. It is crucial that this also includes a cushion to protect you in case repairs or other expenses should arise. Factors such as property location will weigh in significantly as will the architecture’s attractiveness, amenities, and upkeep.
A newer calculation that banks are using is the debt yield ratio. While it may be similar to the debt ratio or the debt service coverage ratio, it is distinct from these other formulas. It has to do with the scenario of foreclosure and informs the lender on the NOI, or net operating income, your property would generate for them, and they will typically want to hit a target of 9% or 10%.
Part of the underwriting process will require the determination of your net worth to loan size ratio. This will necessitate taking your entire financial picture into consideration, as a bank will not want to approve a sum for you that is substantially more than what you currently own. It is a way of making sure you have the wealth necessary to pay back the money you’re asking to borrow.
If your project involves construction, your underwriters will need to figure out your loan to cost ratio. The bank is not going to want to assume all the risk for the building and wants to make sure that your developer will be responsible for a portion of the investment. The ratio can vary, depending on the particulars, but in general, your lender will assume no more than 70-80% of the liability.
Lastly, your profit ratio will be considered for construction lending, and this number helps banks assess how much the developer stands to make on the proposed venture. This is vital, as costs very often tend to go over, as contingencies frequently arise during building. The higher the amount, the greater the likelihood that the developer will follow through on his or her commitment instead of walking out if he or she runs into problems.
Fidelman & Co. specializes in management consulting, presentation advisory, and financial modeling. We focus on building businesses alongside entrepreneurs and investors. Contact us today for more information about what we can do for you.