Commercial loans use many terms that are unique to the industry. Below are some commercial loan terms and definitions that you are likely to encounter when obtaining a commercial loan.
The collateral for a commercial loan can be almost anything that has some intrinsic value. Different types of loans are often defined by the type of collateral that can be used to secure them. Generally speaking, the borrower will pledge the collateral as security to the lender so that the lender has a mechanism to recover his capital should the borrower not perform according to the loan agreement.
Debt Service Coverage Ratio
The Debt Service Coverage Ratio (commonly referred to as “DSCR”) is a ratio, generally expressed as a decimal number, between the EBITDA and the payments required for the loan. For example, if your apartment building has an EBITDA of $125,000 per year and the sum of your loan payments (which includes both principal and interest but not impounds for taxes and insurance) is $100,000 per year, your debt service coverage ratio would be 125:100 or 125/100 = 1.25. This is frequently written as “1.25X”, meaning that the property’s EBITDA is 1.25 times what the loan payment is. Another way of looking at it is that the property has about a 25% “cushion” above what it costs to make the debt service payments.
EBITDA, or “Earnings Before Interest, Taxes, Depreciation, and Amortization” is the source of much confusion for borrowers seeking commercial financing. What is considered to be in the “Before” group that gets excluded (or “added back”) is usually the most confusing factor because loan underwriters do not look at EBITDA the same way as accountants or investors do. There is no hard and fast rule for what is included and what is not. Ultimately, that determination is at the discretion of the lender and varies somewhat by loan type. The simplest method for a real estate-based commercial loan is to take the property’s net income and then “add back” the mortgage interest, taxes (income taxes, not property taxes or sales taxes), and depreciation & amortization on the property improvements.
For more general information on the use and calculation of EBITDA, see Wikipedia’s description of EBITDA.
For commercial lending purposes, these guidelines usually apply:
- The only interest that’s excluded from the EBITDA calculation is interest on the debt that is the subject of the analysis. For example, if you are refinancing a real estate loan on your property that costs $100,000 per year in interest and there is another loan for manufacturing equipment that costs $15,000 per year in interest (and the loans aren’t being combined as part of the refinancing), the $15,000 per year interest expense would not be added back, but the $100,000 per year mortgage interest expense would be.
- Depreciation & Amortization are often added back and replaced with a lender-chosen “maintenance reserve” or “replacement reserve” based upon a percentage of rent or an amount per square foot per year, depending upon the property type.
The Loan-to-Cost (commonly referred to as “LTC”) is a ratio, generally expressed as a percentage, that describes the relationship between the loan amount and the cost of acquiring or constructing the collateral for the loan. For example, if you borrow $700,000 that is collateralized by a piece of property that will cost $1,000,000 to acquire the land, obtain permits and drawings, and build an apartment building on, the loan-to-cost ratio is 700,000/1,000,000 = 0.70 or 70%. This ratio is typically used in the analysis of construction loans.
The Loan-to-Value (commonly referred to as “LTV”) is a ratio, generally expressed as a percentage, that describes the relationship between the loan amount and the value of the collateral for the loan. For example, if you borrow $700 that is collateralized by property with a $1,000 fair market value, the loan-to-value ratio is 700/1000 = 0.70 or 70%.