Whether we like it or not, banks are prudent, and they must comply with federal lending laws. It does not matter whether you agree with their policies. Your only choice is whether to borrow or not.

Most investors buy apartments with a loan. Most of them want to obtain the maximum loan possible. The lender determines that amount. Once you understand how the lenders calculate the loan, you can focus your time and attention on the opportunities and avoid the wasted effort of chasing buildings that are currently beyond your reach.

What lenders want

Lenders want all the prudent loans they can make and don’t want to make any bad loans. Lenders are more conservative than the seller or listing broker or buyer.

Wiser choices come when you understand the assumptions and reasoning behind lenders’ vacancy rates, expenses, and reserve or capital expense figures. Your assumptions are likely to be different. You expect rents to increase, but lenders don’t consider that. You hope that you’ll do better than average. Lenders work cautiously, based on the average borrower.

The critical role of the appraiser

Lenders hire appraisers as prudent, disinterested experts. Appraisers are the sentries who guard against irrational expectations. They remind everyone of the current reality.

Appraisers render a disinterested opinion. The market determines value; appraisers give an opinion of value. Lenders consider several factors, including value, in determining how much to lend. Buyers and sellers also have opinions. If the buyer’s opinion is higher than the appraiser’s opinion, the buyer can literally put his money (extra down payment) where his mouth is. It is legal to pay more than the appraisal, you just make a bigger down payment.

Determining the loan amount

For residential property and for small apartments (fourplex or less), the lender will evaluate your ability to repay the loan by reviewing your credit and reported income. Federal law mandates a different underwriting standard for loans to buy investment property of five units or more.

Above four units, the lender focuses on the asset’s current income. The math behind the lender’s assumptions is based on decades of income property loans.

Generally, the lender will insist that the property have $115 to $125 of cash flow to cover every $100 of mortgage payment. Banks call this relationship the Debt Coverage Ratio (DCR). Lenders will set the loan amount using the most conservative of several methods, including a percentage of down payment, relation to replacement cost, or value of comparable buildings. In San Diego and most other supply-constrained markets, the DCR will be most important in determining the loan amount

Lenders typically consider current income, even when they recognize that rents are far below the market. Underwriters use a conservative estimate of local vacancy, credit loss, and concessions rate to calculate their estimate of collections and thus the gross operating income. Next, they deduct property taxes and other operating expenses to estimate net operating income (NOI), cash flow before the mortgage. The lender’s estimate is usually below what the buyer hopes for.

The lender will put in some further cushion. Over the next 30 years, the property will need appliances, heating and cooling equipment, painting, roof replacement, stair and landing repairs, water heater, windows, and so forth. Many lenders budget about $250 per unit annually.

Lenders have estimated the borrower’s likely cash available for mortgage payments. But the lender is conservative and adds more cushion.

A prudent lender determines the amount of the loan based on the appraiser’s professional opinion of the property value. Following Federal guidelines, the lender calculates the expected gross and net operating revenues.

Higher interest rates boost payments, which shrinks the Debt Coverage Ratio. The NOI does not change when rates change, but the available loan shrinks So, higher interest rates mean bigger down payments.

This post was adapted from my book, Building Legacy Wealth.


Terry Moore, CCIM, is the author of Building Legacy Wealth: How to Build Wealth and Live a Life Worth Imitating. Read his “Welcome to My Blog.

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