Here are 5 essential formulas you need to know
Construction finance can be hard to wrap your head around. From the types of financing available, to how to secure financing, to getting the paperwork under control, there’s a lot to learn and manage. But when it comes down to it, whether your project moves full speed ahead or gets held up in the early phases often rests on the shoulders of the organization financing the venture. And who knows how they determine whether or not your project is worthy of financial support?
Turns out, construction finance is more math than it is mystery. To help you better understand how lenders value your commercial property, we’ve pulled together the essential formulas they use to come to a decision. When it’s time for you to obtain financing from a lender, understanding these key formulas, and how your property measures up, will help put you in the driver’s seat.
The five key formulas lenders use to value your commercial property
Bottom line: lenders want to know your facility has, or is projected to, achieved stabilization. Simply put, that means the venture’s earnings outweigh its debts. How does a lender determine this? In these five ways—strap in, this is a lot to calculate.
1. DSCR or Debt Service Coverage Ratio
Lenders want to know that your property is earning enough to cover any debt. So they calculate your Debt Service Coverage Ratio, or DSCR.
Here’s how they do it. Your DSCR is equal to your property’s net operating income (NOI), divided by the total debt service.
2. NOI or Net Operating Income
To calculate your property’s net operating income, or NOI, your lender will subtract the cost of operations from the annual operating income from your property.
This will not include depreciation, interest or tax write-offs.
3. Debt service
Your property’s debt service is equal to the amount owed in both principal and interest on your property construction loan.
4. Property Value
Your property value is then calculated by dividing its net operating income by the capitalization rate, or CAP rate.
5. Capitalization (CAP) Rate
Your CAP rate is equal to the rate of return on your investment property, oftentimes calculated by dividing the NOI by the total cost of the property.
Understanding how lenders value your commercial property is vital
Altogether, these formulas make up the figures your lender will take into consideration to determine whether your venture has achieved stabilization and is earning more than it owes. In the end, any DSCR figure over one indicates that the investment property is earning enough to pay its debts. However, most lenders require a DSCR of more than 1.25—and if you can achieve that, you may also get a better interest rate on your loan.
No matter how your numbers add up, knowing where you and your investment property stand before you reach out to a lender will put you in a position to make the best decisions possible. Understanding these five essential formulas, you’ll have a clear indication of how a lender will view your request for a loan.