The recent subprime market meltdown, triggered by the rise in home mortgage delinquencies and foreclosures, has caused many banks to be more conservative with their lending practices. Banks that found themselves in financial trouble due to the crisis are scaling back on their lending, resulting in a smaller number of banks lending money to borrowers.
Due to this decrease, borrowers have to be more diligent during the loan process to make sure they are making wise investments.
“Borrowers need to do their due diligence before purchasing an investment property,” says Brad Pascarella, an assistant vice president and commercial loan officer at Brentwood Bank.
Smart Business spoke with Pascarella about what due diligence to do before purchasing an investment property, how the debt service coverage ratio can be useful when leasing property, what banks can offer borrowers during the loan process and what banks are looking for in a good borrower.
What type of due diligence should borrowers do before purchasing an investment property?
As a borrower, you want to make sure that the property covers expenses, including debt, and provides you with monthly cash flow. To determine this, you should ask for current leases along with expenses for the property you are purchasing. Once you have leases, calculate revenue to make sure that the property is able to support expenses along with bank debt and provide you with additional monthly cash flow. This gives the bank a comfort level and a willingness to lend on this property. Banks also look at the area the property is in, which will determine what type of renters they will get. Is it close to shops and businesses or public transportation? You need to make sure the property fits what you’re looking for.
How is debt service coverage ratio useful when leasing property?
Banks utilize the debt service coverage ratio (DSCR) as a tool to review real estate. To calculate debt service coverage, divide net operating income by total debt service for the subject property. A DSCR greater than one indicates a positive cash flow, while a DSCR less than one indicates negative cash flow. Ideally, lenders would want a DSCR of 1.2 or higher. This means that for every dollar of debt that’s out there, there’s $1.20 of coverage. So there’s actually coverage of an additional 20 cents for every dollar coming in to cover any shortages that may occur in the future with that property.
What do banks look for in a good borrower or project?
Banks look for projects with solid cash flow, which means a DSCR of 1.2 times or higher along with adequate collateral coverage to be supported by an appraisal. Banks continue to use DSCR as a measure of how financially solid a project may be. However, in the current market conditions banks are requiring borrowers to have an equity position of at least 20 percent into the project. If the borrower is a company, personal guarantees will also be required. One of the first things a lender will gauge when sitting down with investors is their experience. Is this their first or second property, or is this someone who’s been involved in real estate for 20 to 30 years and knows the ins and outs? Depending on that situation, a banker is going to address the borrower differently. With a borrower who is new to the process, the loan officer will walk the borrower through each step of the loan process. With a more seasoned borrower, since they already have an understanding of the transaction and how they would want to structure the deal, the loan process is faster.
What deals can banks offer borrowers?
Banks will lend up to 80 percent of the purchase price or appraised value — whichever is less. By lending only 80 percent, the customer has 20 percent of their money in the transaction. Hopefully by having some of their money in the transaction, they will be less likely to default on the loan. Banks will also finance investment properties for a period of 15 to 20 years, with interest rates fixed for a five-year period. A bank’s pricing on investment real estate is based on the risk to the bank. The less risky the transaction, the more favorable the interest rate will be. By fixing the rate for only five years, the borrower does receive a lower rate than if they would fix the rate for a longer period of time.
How can a commercial loan officer help during the financing process?
Loan officers are basically a sounding board for borrowers. They will run through the numbers with you and give you an idea of the property’s value. They also might work with appraisers in the process, to make sure the property is not over valued as well.
Brad Pascarella is assistant vice president and a commercial loan officer at Brentwood Bank. Reach him at (412) 409-9000 x239 or [email protected].