RECI Explains Lenders' New Black Box Forumulas

CHICAGO, IL - Lenders are more selective than ever with current underwriting techniques reflecting very conservativeparameters.

And in particular, higher leverage fundings based on project values of the last couple of years are shunned.

Instead, most lenders prefer internal valuation/underwriting models rather than simply applying debt service coverage and leverage restrictions to externally-generated valuations (e.g., purchase contracts and third-party appraisals).

These underwriting models are often known as "Black Box" formulas.

Black Box formulas offer "quick and dirty" answers for initially screening most types of permanent, fixed-rate loans characterized by relatively predictable income streams.

Two of the most popular Black Box formulas are "Front Door"(income-justified loan) and "Back Door" (loan-justified income). Each formula is described below along with a simple illustration.

Front Door:

The Front Door formula is used for computing the justified loan about based on a net operating income.

In summary, the debt service coverage ratio is capitalized by the mortgage constant, as shown by the following example:

* If a project has a projected figure of $1 million stabilized net operating income; the cash flow available for debt service would be $833,333 ($1,000,000 divided by 1.20 debt service coverage).

* Thereafter, capitalizing the cash flow available for debt service at an 8% constant equates to a loan amount of approximately $10.4 million.

* Dividing the loan amount by 75% equates to a rounded value of $13,900,000.

* The original $1 million of net operating income translates to a capitalization rate of about 7.2%.

Back Door:

In contrast to Front Door loan underwriting needed for sizing project income, the Back Door uses the required loan amount as the key variable.

The debt service coverage ratio determines the minimum net operating income as illustrated below:

* $10.4 million is the requested loan amount featuring an 8% mortgage constant restricted by a 1.20X DCR and a 7% cap rate.

* Multiplying the requested loan amount by the 120% yields a net operating income of $998,369.

* Capitalizing the net operating by 7% yields a value in excess of$13.3 million with a corresponding LTV of about 78%.

Loan Proceeds Restrictions:

The Front and Back Door formulas are often restricted by the lower of: (a) Loan-to-Value or (b) debt service coverage ratio.

For example, in the case of the Back Door method, the loan may be limited to 75% rather than 78% (even though the debt service coverage complies at 1.20X).

Return-on-Cost Targets:

The Return-On-Cost is based on capitalizing the projected, stabilized net operating income by the total project costs.

ROC calculations are especially useful for quickly computing justifiable project costs for new construction/substantial rehab ventures projects.

Generally speaking, ROC yields should be at least 100 to 250 basis points higher Front and Back Doorcap rates.

In the above examples, the project should generate cost returns of at least 8% to be reasonably profitable.

In the cast of the Front Door example, the development should be built based on total costs of approximately $12.1million-or-less to be considered a "profitable" development opportunity

.Limitations:

Black Box formulas are limited to static underwriting situations.

Unlike dynamic underwriting formulas such as discounted cash flow analysis, static underwriting assumes a stabilized net operating income which increases or remains flat during the loan term (e.g., multifamily or net-leaseproperties). If the cash flows are expected to significantly fluctuate and/or are in the process of stabilizing, Black Box formulas generate inaccurate results.

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