Our co-op has been searching for a new underlying mortgage, and most of the banks we’ve contacted have told us that our “LTV” is too high. Apparently, that has something to do with the value of our building. However, since our apartments sell for between $250,000 and $400,000, we don’t see a problem with our value. Are the lenders playing games with us?
The lending community uses lots of jargon. One of the most common terms is “LTV,” or “loan to value.” LTV is almost always expressed as a percentage, and that percentage is calculated by dividing the proposed new loan by the estimated value of your property. Despite the “no money down/100 percent financing” hype of late-night infomercials, most lenders limit their lending to some lesser percentage of a property’s value, usually no more than 75 percent. In addition, many lenders tie their pricing to LTV, with lower LTV properties getting more favorable rates than those with higher LTVs.
The issue of LTV often causes a problem because borrowers and lenders view a property’s value from different perspectives. When most co-op residents think of their building’s value, they typically multiply the most recent apartment sales price by the number of units in their building. For your co-op, you might use an average sales price of $325,000 per apartment times the nine units in your building to arrive at a “value” of $2,925,000. So the new loan of $1,400,000 that you’ve been seeking – which would give you an LTV of 48 percent – seems perfectly reasonable.
Lenders, on the other hand, calculate value a little differently. A lender’s biggest fear is that a borrower will not make his or her monthly payment, forcing the property into foreclosure. Foreclosure is a legal process through which a lender can take a property away from the borrower by exercising certain rights acquired under the mortgage that the borrower signed at the loan closing. However, lenders do not want to own property. Therefore, whenever they acquire a property through foreclosure, they almost always put it up for sale.
So, when lenders think about value, they don’t care what the borrower says their property is worth or even what the borrower may have paid for it. From the lender’s perspective, a property’s value is the price that it will bring in a quick foreclosure sale. And that value is a little more difficult to determine…especially when the borrower’s property is a cooperative apartment building.
When a cooperative defaults on its underlying mortgage, the lender will probably move to foreclose. If completed, the foreclosure will dissolve the apartment cooperation and convert the property to a rental. Whether any lender actually could accomplish such a conversion in today’s legal and political environment is fodder for another article. Nonetheless, that’s what goes through a lender’s head when considering value.
Let’s look at your building through a lender’s eyes. First, we’re going to pretend that your building is a rental and ascribe a fictitious rent to each of your apartments. If we assume that all nine of your units rent for an average of $3,000 a month, the maximum possible gross income for your building would be $324,000 per year. Most lenders will expect that some of your apartments will be vacant at least some of the time and adjust the total possible rent by some amount (say, five percent) to account for tenant moves, market slumps, and other rent reductions. After allowing for these factors, we have an adjusted gross income of $307,800.
Your current operating expenses run roughly $170,000. Most lenders will increase various line items (like real estate taxes and heating oil) to allow for inflation (let’s assume an average increase of six percent). They most likely will increase your insurance coverage. They also will add a full-service management fee (about five percent of adjusted gross income) and an amount for maintenance, repairs, and replacements ($1,000 per unit per year or more). After making these adjustments, your total operating expenses will come to $204,590. If we deduct that amount from the adjusted gross income, we are left with a net operating income (or “NOI” in lenderspeak) of only $103,210.
This NOI represents the annual cash flow that an investor would receive if the investor bought your building paying all cash. The amount that a real estate investor would be willing to pay depends on the rate of return that it would require for a new investment. If an investor wanted an annual return of seven percent, we could estimate the value of your building by dividing the NOI of $103,210 by seven percent to get $1,474,429.
Lenders refer to this calculation as “capitalizing the net operating income”, and they call the seven percent return a “cap rate.” If we then apply the common maximum LTV of 75 percent, we get a maximum new loan of $1,105,821…let’s round that to $1,100,000. It’s pretty clear that a new loan of $1,400,000 is excessive…at least to most lenders.
Knowing why lenders are rejecting your loan request is, I suspect, of little comfort. However, it might help you find a solution. For example, you might assemble data on apartment rentals in your neighborhood. If you can document higher rents than those the lender assumed, you might get your loan amount increased. You also should take a hard look at each line item in your operating budget to capture any cost savings. Finally, you can borrow less and either scale back your capital plans or supplement your smaller new loan with shareholder assessments.
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