The Most Important Commercial Loan Underwriting Ratio That There Is

Leverage Ratio, Commercial Real Estate, Credit Risk

We are often asked what is the single best measure of lending risk?  Is it loan-to-value ratio?  Is it interest-coverage ratio?  Is it debt-service-coverage ratio?  Is it liquidity ratio?  While there is no single measure that can be used and each of these measures are important in various underwriting circumstances, if we were stranded on a deserted island and could only bring one tool to measure our underwriting risk, it would be debt-to-cash flow ratio (this is typically called the “leverage ratio”).  The leverage ratio is the measure of the borrower’s debt divided by the borrower’s cash flow.  It measures the number of years of cash flow it will take the borrower to retire the debt (service of the debt is not measured).  This ratio is used in senior lending, mezzanine financing, equity valuations and in enterprise purchases and sales.


While we are big fans of the debt service coverage ratio (DSCR), it is a current, rather than a prospective measure. This is why the leverage ratio just inches out the DSCR for our favorite as unlike DSCR, the leverage ratio is unaffected by amortization, current interest rates and one time surges in cash flow. The leverage ratio is applicable and important across almost any lending sector which is another advantage of the metric.  


Whether you measure debt net of cash or gross, whether you include capital leases or exclude them, whether you measure debt at market value or book value, whether you include contingent liabilities and guaranties, all of these nuances can be debated.  But ultimately the differences do not materially change the analysis in all but the most esoteric circumstances.


What is the correct measure of cash flow? Most bankers understand the concept of “net operating income.”  This represents the cash available after subtracting expenses and is the capacity to pay interest and pay down debt.  Free cash flow from operations is another measure of ability to service debt and has the added benefit of including the effect of working capital changes which is very important for growing business.  However, the king of cash flow measure (hands down when comes to prevalence and usage among debt and equity analysts) is EBITDA.  EBITDA stands for earnings before interest, taxes, debt and amortization.  One drawback of EBITDA is that it does not measure capital expenditure or changes in working capital.  However, that adjustment can be included in the measure.


What is puzzling is that in the world of commercial real estate underwriting, very little consideration is given to the king of risk measure – the leverage ratio.  That is indeed a pity.  The leverage ratio is empirically, both in down and up cycles, the best predictor of default and the best covenant to allow lenders to enforce timely changes to the borrower’s business in the event of a breach.


We have a hunch why most CRE lenders do not pay attention to the leverage ratio.  We also think it is the reason that regulators do not like CRE lending and pressure community banks to diversify their loan portfolio away from “dirt.” 


We created a calculator that takes very simply inputs: such as loan amount, LTV, interest rate, amortization period, and cap rate.  The calculator then shows the following outputs: borrower’s payments, cash flow, Debt-Service-Coverage ratio and the leverage ratio (Debt divided by EBITDA or NOI).  The calculator shows why regulators are pressuring banks to limit CRE exposure.  For decades regulators have considered leverage ratios above 6.0X to be unacceptable. 


The average real estate loan in today’s market, which has the following parameters: 25-year amortization period, priced at 5.00%, 75% LTV, and a 7.5% cap rate has a respectable DSC of 1.43% (certainly a bankable loan at most institutions). However, that same loan has a leverage ratio of 10.0X.   In order to get the leverage ratio to 6.0X, the LTV has to drop to 45%.  Should rates rise and property values/cap rates drop, leverage is further increased on a forward basis. The is in part the answer to the piece we ran last Monday (Here) where we showed that C&I defaults were running about 81bp compared to 1.94% for commercial real estate. If you adjust for leverage, these numbers come back in line.


The calculator certainly casts interesting light on the inherent risks of CRE lending especially because it highlights the high positive correlation between asset values (secondary form of repayment) and cash flows (when the cash flow is not there, neither is the asset value).  As a general rule, the higher the leverage, the more stable the cash flows should be to offset the risk.


If you would like to receive our calculator, please click HERE and go to our Resource Center to download for free. Should you have any questions on our methodology or logic, please contact us and we would be happy to further explain how the leverage ratio can be used across lending types to give your bank and added underwriting advantage.