How do lenders size a commercial real estate loan?

Loan to value

The simplest test: loan divided by appraised value, capped at whatever the lender's program allows. It is the least informative of the three because it depends entirely on an appraisal, and an appraisal depends on a cap rate, which is the thing most likely to have moved since the last comparable sale.

Debt service coverage ratio

Coverage is net operating income divided by annual debt service. A 1.25x minimum means the property must produce twenty five percent more income than the loan payment consumes. To size from it, invert the calculation: maximum debt service is net operating income divided by the required coverage, and maximum loan is that debt service divided by the mortgage constant.

The mortgage constant is annual debt service per dollar of loan, and it is where the rate and the amortization schedule enter. At a six percent rate on a thirty year amortization the constant is roughly 0.0719, so every dollar of annual debt service supports about fourteen dollars of loan. Shorten the amortization to twenty five years and the constant rises, the loan shrinks, and nothing about the property changed.

Most lenders test coverage at a stress rate rather than the contract rate, and some test it on a stress constant with an assumed amortization even when the loan is interest only. Always ask which.

Debt yield

Debt yield is net operating income divided by the loan amount. A nine percent floor means the lender will lend at most about eleven dollars for every dollar of net operating income. It became the discipline of choice after the last cycle because it contains no rate assumption, no amortization assumption and no appraisal. It is the only one of the three tests that cannot be loosened by a friendly assumption.

That is exactly why it binds in hot markets. When values run ahead of income, loan-to-value and coverage both stay comfortable while debt yield does not.

Which constraint binds, and what it tells you

In a low rate environment coverage is easy, and because low rates push values up relative to income, the loan-to-value cap is loose too, so the debt yield floor is usually what binds. As rates rise, the constant rises with them and coverage starts binding first, which is why proceeds fell across the board when rates repriced even though nothing happened to the buildings. In a wide-cap market, where value is low relative to income, loan-to-value takes over.

The practical consequence is that a sponsor who models a fixed leverage percentage is modeling a fiction. Leverage is an output of whichever test binds, and it moves during diligence.

Interest only, refinance risk, and the second loan

An interest-only period raises coverage and cash-on-cash for as long as it lasts, and it hides nothing about the loan itself, only about the year the amortization starts. Model the year it burns off, not the average.

Refinance risk is the same three tests applied at a future date to a future net operating income at a future rate. If the takeout loan is smaller than the balance, the gap is equity, and it is due whether the plan worked or not.

Altyst sizes debt on a loan-to-value cap, a minimum coverage test at a stress rate, or a debt yield floor, whichever binds, and reports coverage and debt yield by year. It supports an interest-only period, amortization, senior and mezzanine tranches, and a bridge to refinance with cash-out.