How Lenders View Valuation of Residential Multifamily Properties

Property Analysis   Property Address: Upper West Side Brownstone Purchase Price: $4,450,000 Proposed Mortgage Amount:  $3,250,000     Gross Annual Residential Income:  $470,088 Less 5% Vacancy Allowance: ($23,504)  Sub-total:  $446,584 Less 5% Management Fee: ($22,329) Sub-total: $424,254 Less Other Total Expenses:* ($85,000) Net Operating Income: $339,254     Desired Loan Amount: $3,250,000 Assumed Interest Rate: 4.75% Amortization (Years): 25 Mortgage Payment (Monthly): $18,529 Estim. Annual Mortg. Payment: $222,346 X 1.25 Debt Service Coverage $277,932     Max. Loan at 1.25 Debt Serv. Cov.: $3,967,071     Debt Serv. Cover. at Desired Loan A 1.53 *- These expenses typically include: Real Estate Taxes, Water & Sewer, Fuel, Utilities, Payroll, Repairs & Maintenance, Legal & Accounting, Replacement Reserves, Misc.         How Property Will Be Appraised:       Net Operating Income: $339,254 Divided by Cap Rate: 8% Prop. Value by Income Approach: $4,240,680     Property Value by Comparable Sales Approach:   $4,450,000     AVERAGE OF BOTH METHODS: $4,354,340 Loan to Value Ratio: $74.79%

Start with the gross annual income: [$470,088]

1) Now subtract a 5% vacancy allowance from that number: [-$23,504 = $446,584]
2) Now take that result and subtract a 5% management allowance: [-$22,329 = $424,255]
3) Next subtract the actual current expenses (We’ll assume $85,000 for this example). Remember to include all other typical categories such as: RE taxes, water and sewer taxes, fuel, utilities, payroll, repairs and maintenance, legal & accounting, replacement reserves, and miscellaneous (each lender will have their own way of estimating these expenses based on their past experiences). For small buildings with 10 or fewer units, some lenders will plug in $300 or $400 per unit for management expenses rather than 5% of the income).
4) The resulting number is your net operating income (NOI). [$339,254]
5) Now plug in the annual interest and principal payments for your proposed mortgage amount with a realistic “ballpark” estimate for the interest rate and amortization schedule. As of 6/18/03, let’s assume a 4.75% rate amortizing on a 25-year schedule: [$226,478]
6) You should now be able to multiply your annual debt service by 1.25 and get a number equal to, or less than, the net income [$339,254]. If the property you are seeking to buy passes this test, then there are probably a number of lenders who will be interested in financing it for you. If your prospective purchase does not pass the test, reduce the loan amount until it does. This will give you a very realistic way to “screen” properties to see what you can comfortably afford to buy.
7) This example yields a debt service coverage ratio (DSCR) of 1.53, which is comfortably better than the minimum 1.25 coverage that most lenders would seek (Net Operating Income [NOI] = $339,254, divided by (annual debt service $222,346) = 1.53. Although the required DSCR varies according to property type and from lender to lender, it is a simple enough concept. It is essentially a “cushion” that assures the lender that even if some income is lost during the course of the loan term for some reason, the borrower will still have sufficient income to service the mortgage on the property.
Even when a building passes the DSCR test comfortably (as in this example), there are other parameters that lenders and appraisers use that may limit the loan amount, such as what capitalization rate is deemed appropriate, and whether the lender gives more weight to the income approach or to the sales approach.

There are plenty of variations on the theme of how different lenders evaluate, define valuations and establish loan amounts based on many details that are not readily apparent to the borrower. However, a conceptual understanding of how lenders approach underwriting a multifamily loan will be helpful if and when you or your client are exploring this market


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