Loan sizing
Also called Debt sizing, Maximum loan proceeds.
Loan sizing is the process of determining the maximum loan proceeds a property supports. A lender runs three independent tests, a loan-to-value cap, a minimum debt service coverage ratio at a stressed rate, and a minimum debt yield, and lends the lowest of the three.
How it works
The three tests exist because each fails in a different environment. LTV depends on an appraisal and loosens when values are inflated. DSCR depends on the interest rate and loosens when rates are low or when the loan does not amortise. Debt yield depends on neither and is the backstop for both. Running all three and taking the minimum is not conservatism, it is the actual mechanic, and a model that assumes any single one of them will bind is guessing.
Which test binds tells you something about the market. When cap rates are low relative to rates, values are high relative to income and the income-based tests bind first. When cap rates are wide, LTV binds. Knowing which constraint is active also tells you which negotiation is worth having: if debt yield binds, arguing about the appraisal is wasted effort.
The stress is the part borrowers most often miss. Lenders do not size DSCR at the note rate. They size at an underwriting rate, frequently a floor rate or a spread over an index, and on an amortisation schedule that may be shorter than the actual one, so the coverage that governs proceeds is tighter than the coverage the borrower will experience.
Formula
Maximum loan = the minimum of (value x LTV cap), (NOI / minimum DSCR / stress constant), and (NOI / debt yield floor)- The stress constant reflects the lender's underwriting rate and amortisation schedule, not the note terms
- Value on a purchase is normally the lesser of appraised value and contract price
- Every test uses the lender's underwritten NOI, which normally deducts reserves and normalises taxes and insurance
Worked example
NOI $3,020,000, price $55,900,000. Lender terms: 65 percent LTV, 1.25x minimum DSCR, 8.25 percent debt yield floor. The loan is three years interest only at 6.35 percent, then a thirty-year amortisation schedule, so the coverage test has two answers.
| LTV test: 65% of $55,900,000 | $36,335,000 |
|---|---|
| DSCR test, interest only at a 6.35% constant | $38,047,244 |
| DSCR test, 30-year amortisation at a 7.467% constant | $32,356,442 |
| Debt yield test: $3,020,000 / 8.25% | $36,606,061 |
| Governing constraint | LTV while the loan is interest only, DSCR once it amortises |
| Maximum loan proceeds | $36,335,000 interest only, $32,356,442 amortising |
The interest-only period is worth $4.0 million of proceeds, and that is its economic function. It is also why the coverage the lender tested at origination is not the coverage the property runs from year four, when this loan drops to 1.11x. Size on the amortising constant unless the term sheet says otherwise in writing.
The common mistake
Sizing on the note rate rather than the lender's underwriting rate
A borrower computing the DSCR test at a 5.75 percent interest-only constant gets $42.0 million of proceeds. At a 6.35 percent interest-only constant it is $38.0 million, and on the 7.467 percent constant the loan actually amortises at, $32.4 million. Neither calculation is wrong; only one of them is the one that governs, and it is normally the amortising one. Ask for the underwriting rate, the underwriting amortisation schedule and the NOI adjustments in the term sheet discussion, and size the equity on those, because a proceeds shortfall discovered at loan approval is an equity problem with a closing date attached.
Related terms
- Loan to valueLoan to value is the loan amount divided by the property's value, expressed as a percentage. It is the most familiar leverage constraint and, on a purchase, is normally tested against the lesser of the appraised value and the purchase price.
- Debt yieldDebt yield is net operating income divided by the loan amount, expressed as a percentage. It measures the return a lender would earn on its loan if it took the property back and operated it, and unlike DSCR it is unaffected by interest rate, amortisation schedule or loan term.
- Debt service coverage ratioThe debt service coverage ratio is net operating income divided by annual debt service. A 1.25x means the property produces $1.25 of income for every $1.00 of principal and interest owed, so net operating income could fall by 20 percent before coverage reaches 1.00x and the loan stops being covered.
- Loan constantThe loan constant is annual debt service divided by the original loan balance, expressed as a percentage. It combines the interest rate and the amortisation schedule into one number, which is what makes it the right rate to compare against a cap rate.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
- Loan to costLoan to cost is the loan amount divided by total project cost. It is the leverage constraint used on construction and heavy value-add loans, where the property has no stabilised value to lend against and cost is the only verifiable basis.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.