Loan Sizing | Real Estate Formula + Calculator (2024)

How Does Loan Sizing Work in Real Estate?

In the commercial real estate (CRE) industry, the reliance on debt financing to fund projects is an inherent attribute of the strategies used by investment firms to achieve their target returns.

If access to “cheap” debt capital in the credit markets is readily available, the real estate market tends to exhibit higher transaction volume (i.e. the total number of transactions that occur in a given period) due to the rise in buying power.

The cost of debt, or interest rate pricing, is one of the core drivers of market demand from buyers, which has broad implications on property valuations.

The more leverage used to fund the purchase of a property, the greater the return on the investment – all else being equal.

Why? The equity contribution required by the commercial real estate investor declines, causing the potential upside on the return on equity (ROE) to increase at exit.

• Positive Leverage (Project Return > Cost of Debt) → Higher Return on Equity (ROE)
• Negative Leverage (Project Return < Cost of Debt) → Lower Return on Equity (ROE)

Hence, real estate investors have the economic incentive to reduce the size of their equity contribution on the date of initial purchase as much as possible.

Contrary to an equity investor, the return on senior debt is “capped” since the sources of yield are the receipt of periodic interest and principal amortization.

Therefore, commercial lenders prioritize capital preservation, which entails mitigating downside risk to avoid incurring a capital loss on a financing.

How to “Right-Size” a Commercial Loan

The underwriting process differs per lender and is affected by various factors, such as the real estate project type (e.g. strategic value-add acquisition, property development project), the track record of the borrower requesting the loan, and current market conditions.

The centerpiece of the underwriting process is loan sizing, whereby a commercial lender performs a cash flow analysis of the underlying property to determine the maximum loan amount (“ceiling”) to offer to a potential borrower.

The implied maximum loan amount, however, should not be interpreted as the right amount to provide. Instead, the maximum loan is merely an upper parameter to not exceed.

Based on insights derived across the entire underwriting process, the size of the loan can be adjusted downward accordingly to ensure there is a “cushion” for underperformance.

The size of a commercial loan, such as a CMBS conduit loan, is predicated on the property’s cash flow, or net operating income (NOI).

Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Property Expenses

But unlike CRE investors, who focus on the pro-forma NOI at stabilization, lenders are far more focused on the historical cash flow of the property, as well as the downside case in the pro-forma forecast.

From the perspective of a lender, an overly conservative analysis is preferable to an overly optimistic analysis, since a lender is a debt investor.

While there are various external factors that can cause the yield earned by the lender to deviate from original expectations (e.g., interest rate risk), the one risk deemed more manageable is the risk of default.

Generally put, the quality of a given real estate asset, like an office property, is the primary determinant of the total loan size (and thus, the focal point of the analysis).

The reason? Commercial lenders tend to be conservative rather than yield-oriented, and require the borrower to pledge the property as collateral as part of the financing arrangement (i.e. lien).

In the event of default – i.e., if the borrower misses a scheduled interest payment or is unable to repay the principal in full at maturity – the senior secured lender has a rightful claim on the asset.

Commercial Lending Loan Sizing Metrics

The credit metrics used to analyze the risk attributable to a particular loan proposal vary case-by-case – or more specifically, the “weight” of each metric is a function of the particular circ*mstances of the financing.

With that said, the three fundamental credit metrics that form the basis of loan sizing in the commercial real estate (CRE) industry are as follows:

1. Loan to Value (LTV)
2. Debt Service Coverage Ratio (DSCR)
3. Debt Yield (DY)

For each of the three credit metrics, lenders place constraints to ensure the risk of default is kept to a manageable level based on the cash flow profile of the property (i.e. to “right-size” the loan).

Of course, there are plenty of other metrics to measure the risk of providing capital to a certain borrower, but analyzing the most common trio of ratios (LTV, DSCR, and DY) is widely recognized as the industry standard methodology to right-size the loan amount.

How to Perform Loan Sizing in Real Estate

1. Calculate Loan to Value (LTV)

Loan-to-value (LTV) is a ratio that compares the size of a commercial loan to the market value of the underlying property pledged as collateral to secure the financing.

The formula for calculating the loan-to-value ratio (LTV) divides the total loan size by the property value as of the present date.

Loan to Value Ratio (LTV) = Loan Amount ÷ Property Value

Where:

• Loan Amount → The size of the loan provided by the lender (or the amount needed by the borrower).
• Property Value → The market value of the property, most often estimated via an independent appraisal.

Since the loan-to-value ratio (LTV) is denoted as a percentage, the resulting figure must be multiplied by 100.

Commercial lenders prefer a lower loan-to-value (LTV) ratio, because that creates the need for a larger down payment from the buyer, i.e. more equity is required to close.

• Lower LTV Ratio → Higher Down Payment (More Equity Required to Close)
• Higher LTV Ratio → Lower Down Payment (Less Equity Required to Close)

In the commercial real estate (CRE) industry, the maximum loan-to-value ratio (LTV) is widely accepted to range around 70% to 80%.

The increased equity contribution implies the buyer has more “skin in the game”, effectively aligning the incentives of both parties with a vested interest in the outcome of the financing.

2. Calculate Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio (DSCR) determines if a property’s cash flow is sufficient to cover its debt obligation.

The DSCR is calculated by dividing the net operating income (NOI) of a property by its annual debt service, which includes interest and principal amortization.

Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) ÷ Annual Debt Service

Where:

• Annual Debt Service = Interest + Principal Amortization

Commercial lenders set the minimum DSCR constraint near 1.25x, which is widely recognized as the industry norm among practitioners.

However, there tends to be more leeway with the DSCR based on the stability of the property’s cash flow, unlike the 80% LTV rule.

3. Calculate Debt Yield (DY)

The debt yield measures the riskiness of a commercial loan by quantifying the return earned by the lender to recover the original contribution in the event of default.

The formula for calculating the debt yield is the ratio between the net operating income (NOI) of a property and the total loan size, expressed as a percentage.

Debt Yield (DY) = Net Operating Income (NOI) ÷ Total Loan Size

Commercial lenders prefer a higher debt yield because that implies the financing presents less default risk.

• Lower Debt Yield → If the debt yield is low, there is more risk placed on the lender from the instability of the property’s operating cash flow, which could fall short in meeting the debt burden.
• Higher Debt Yield → In contrast, the higher the debt yield, the less risk put on the lender due to the reduced probability of the borrower defaulting on the financial obligation.

The minimum debt yield benchmark is most often cited as 10% (or 8% to 12%).

The distinct attribute of the debt yield is that the metric is unaffected by fluctuations in the prevailing interest rate and maturity term of the loan.

Once the debt yield has been determined, lenders can estimate the number of years necessary to recoup the loss incurred on a foreclosed property.

Recoup Time = 100 ÷ Debt Yield (DY)

Maximum Loan Amount Formula

Since we’ve covered the three main credit metrics, we’ll shift to applying each to estimate the maximum loan amount.

Starting with the loan to value (LTV) ratio, the maximum loan amount is the maximum LTV ratio multiplied by the property value.

Maximum Loan Amount = Max. Loan-to-Value (LTV) × Property Value

The debt service coverage ratio (DSCR) is distinct because the lender’s constraint is set based on a minimum DSCR ratio.

For instance, the borrower’s cash flow cannot dip below the min. DSCR of 1.25x.

For our third credit metric, the maximum loan amount is equal to the NOI divided by the debt yield.

Maximum Loan Amount = Net Operating Income (NOI) ÷ Minimum Debt Yield

Once the implied maximum loan amount has been determined under each metric, the lender usually picks the lowest value to serve as the upper parameter.

Note: The lender often adjusts net operating income (NOI) downward to be more conservative, akin to the lender-adjusted EBITDA in M&A.

Loan Sizing Calculator – Excel Template

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

Real Estate Loan Sizing Calculation Example

Suppose we’re tasked with performing loan sizing on a financing proposal received from a commercial real estate (CRE) investor.

The underwritten NOI, or lender-adjusted NOI, is $2 million, while the cap rate is 8.0%. Therefore, the implied property value comes out to $25 million.

• Property Value = $2 million ÷ 8.0% = $25 million

The borrower requested a loan of $16 million as part of the financing proposal, with an amortization period of 25 years and an interest rate of 6.5%.

• Target Commercial Loan = $16 million
• Amortization Period = 25 Years
• Interest Rate (%) = 6.5%

The lender’s constraints, or requirements for the loan-to-value ratio (LTV), debt yield, and debt service coverage ratio (DSCR), are 70%, 8%, and 1.25x, respectively.

• Max. LTV = 70.0%
• Min. DY = 8.0%
• Min. DSCR = 1.25x

The implied maximum value per tranche is $17.5 million, $25 million, and $19.5 million.

The maximum loan value to offer is the lowest one out of the three, which we’ll determine using the “MIN” function in Excel.

=MIN(J11:J13)

Given those parameters for the financing assumptions, we can derive the loan-to-value ratio (LTV), debt yield (DY), and debt service coverage ratio (DSCR).

• Loan-to-Value Ratio (LTV) = 64.0%
• Debt Yield = 12.5%
• Debt Service Coverage Ratio (DSCR) = 1.52x

Therefore, the maximum loan that the lender can offer, considering the three constraints, is $17.5 million.

• Maximum Loan = $17.5 million
• % Cushion = ($17.5 million ÷ $16 million) – 1 = 9.14%

The loan proposal passes each condition with a sufficient “cushion” to further protect the lender’s downside risk potential from potential underperformance.