Previously, we looked at features of unsecured and secured debt lending, specifically difference between unsecured consumer debt at major platforms such as Lending Club vs real estate based business lending on Reamerge. We went into details regarding real estate capital stack structure and how each position (senior vs mezzanine vs equity) gets paid out if the borrower defaults.
In this post we briefly go, superficially, into the underwriting criteria by Reamerge to evaluate the business cashflow and its underlying real estate as it relates to the margin of safety. In general, businesses that borrow on REAMERGE platform are:
- FICO (Fair Isaac Corporation) Score – of 650+ of the borrower
- Debt to Service Coverage ratio of greater than 3
- Loan-to-Value (LTV) or Loan-to-Business-Value (LTBV) of 65% or less
Let’s discuss the last two in some detail
Debt Service Coverage Ratio:
DSCR in short, is a financial ratio that measures the borrowing business’s ability to pay its current debts by comparing the business net operating income with its total debt service. In essence, it is looking at business’s available cash with its current interest and principle obligation. This is probably one of the most looked at ratio by creditors. It’s not always about cash flow – what good is cash flow if you have a lot of debt! The formula is simple
DSCR = Net Operating Income / Total Debt Servicing costs
What is Net Operating Income (NOI) you may ask? On an income statement, you will see NOI as net operating income that is left over after all the operating expenses are payed off. This is before earnings before interest and taxes or EBIT. The denominator represents servicing costs of the business’s debt. This includes interest payments, principle payments etc.
What should you look for? DSCR demonstrates business ability to pay debt. So if a ratio is 1, the business is operating neck to neck. That is to say the business generates just enough to pay its debt. The higher this ratio, the more ability the business has in servicing its debt.
Lets go through an example – suppose XYZ Doctor’s office wants to expand its services and make a small “in house” pharmacy. The doctor’s office already has some loans on the business and primary real estate. Here is how we would calculate DSCR for XYZ:
Interest Expense (other loans) $80,000
Principle Payments (other loans) $55,000
Then DSCR = 1.33
This means that after making current debt payments XYZ has 33% of it’s profit left to either make payments on current loans or take it as profit.
LOAN TO VALUE RATIO (LTV):
Loan to value ratio is simple the loan the borrower wants divided by the property’s value. A quick example is if the property value is $200,000 and borrower requests $150,000 then LTV is 75%
As you can surmise, the higher the LTV, the higher the risk. In certain situations the overall value of a business is combined with it’s underlying property – for example consider a grocery store that owns its own property. The property value may be $400,000 but the goodwill of the business it self is $300,000, and thus in calculation you can include the “value” to be market value of $700,000.
One more ratio that you may sometimes see is DEBT TO EQUITY ratio. The figure below demonstrates it nicely.
Credit officers look at this number but keep in mind different businesses have their own benchmarks. Still, a debt to ratio of greater than 0.5 is considered risky. Imagine if it is 0.7 then for every dollar the business earns, 70 cents go servicing debt! There should always be a good equity “cushion” that provides investor with the necessary margin of safety should the borrower default on a secured loan.
Above is a quick and superficial discussion of a few ratios that may be considered in loan underwriting. This overview is necessarily simplified for investors to have tools to evaluate deals before investing. There is much more to underwriting than simple ratios and involves years of data on market risk, and business risk that is not so easily encompassed in ratios. Nevertheless, a nice overview of business strength can be ascertained from these easy to calculate ratios.
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