How banks (should) think about risk
Have you ever wondered why banks think in terms of debt service coverage ratio (DSCR) and loan-to-value ratio (LTV) when they’re considering whether to lend you money to buy property?
They’re really thinking about two different things:
1. Whether you’ll be able to pay the mortgage (DSCR test). This is where the DSCR comes in. The bank wants to see that the net operating income (NOI) from the building (the rents minus the expenses, including property tax but not mortgage) exceeds the total mortgage payments by a healthy margin (right now, by a ratio of $1.20 of NOI for every $1 of debt service).
The cushion (the $0.20 difference) is meant to ensure that, if the rents go down or the expenses go up (something breaks, etc.), you’ll have enough money coming in to cover the mortgage. And, indeed, this has worked very well for banks, as evidenced by the fact that very few 5+ unit buildings have gone into foreclosure over the past four years. (Believe me, I was licking my chops in anticipation of a meal that never arrived at my table!).
2. What happens if you default (LTV test). In the event of default, the bank will move to take title to the property via a trustee’s sale. This is a fairly complicated process, but it boils down to this: An auction is held. If someone wants to pay more for the building than the bank is owed on its loan, then the bank is repaid in full (plus expenses) and the bidder gets the property.
But if no one bids more than the bank is owed, the bank gets the property. Here’s where the LTV test comes in. If the bank required you to put down 30% to buy the property in the first place, it only loaned you 70% of the market value. If you then default and the bank takes the property back, it’s theoretically getting the property for a price equal to 70% of market value. Even if something has changed about the property and it has become less valuable, the bank still has a pretty good chance to at least get its money back.
Imagine, on the other hand, if the bank lent you 96.5% of the value (like FHA does). If you default in that scenario, the bank is very unlikely to be fully re-paid, in part because the cost of doing the trustee sale will likely erase the 3.5% discount the bank is getting. This is why the only way banks will do these kinds of loans is if the government steps in and insures the bank against losses in event of default (that, in a nutshell, is what the FHA program does).
Some final thoughts: Based on the above, you would think that banks would be very, very happy to loan in high downpayment situations. For example, if I’m willing to put down 50% of the value of an apartment building (a value that’s been checked by an appraiser), the bank should be pretty damn happy to make that loan. After all, the DSCR is going to be high (because I’m borrowing less, the ratio of NOI to mortgage payments is higher). And, the LTV is low (I’m putting down 50% so, if I default, they’re getting the property for half the market value – a steal).
If I were a bank, I would be jumping up and down waving money at people who wanted to do these sorts of loans, almost regardless of their income, credit, etc. And yet banks still seem to require a really thorough, punishing approval process, even for people with large down payments.
It strikes me there’s a business opportunity there – make it really easy to get low LTV loans on apartment buildings and you’d have loads of customers.
Anyway, my $0.02.