Welcome to the third installment of our four-part series on the Four C’s of Lending: Character, Capacity, Capital, and Collateral. In our previous articles, we explored Collateral and Character and their roles in securing a loan. Today, we focus on Capacity, a crucial factor lenders consider when evaluating a borrower’s loan application.
In real estate lending, Capacity refers to a borrower’s ability to repay a loan based on their income, existing debt, and the income-generating potential of the property being financed. Assessing capacity helps lenders determine the risk associated with extending credit to a borrower.
Lenders evaluate Capacity to determine:
- Can this borrower generate sufficient income to cover the loan payments?
- How do the borrower’s existing debts impact their ability to repay new debt?
- Does the property’s income potential support the loan amount?
Understanding Capacity helps lenders mitigate risk by ensuring they work with borrowers who are likely to meet their loan obligations.
Capacity is evaluated through several financial metrics:
Debt-to-Income (DTI) Ratio measures the percentage of a borrower’s gross monthly income that goes toward debt payments. It’s calculated using the formula:
DTI Ratio = (Total Monthly Debt Payments / Gross Monthly Income) × 100
For example, if a borrower has a gross monthly income of $10,000 and total monthly debt payments of $3,000, their DTI ratio is 30%.
What Is an Acceptable DTI Ratio?
- Traditional Banks: Prefer a DTI ratio below 43% for mortgage loans, with 36% or lower being ideal for the strongest borrowers.
- Hard Money Lenders: May accept higher DTI ratios (sometimes up to 50% or more), especially if the borrower has significant assets or strong property cash flow.
Why DTI Matters:
- Lower DTI Ratios indicate that a borrower has a manageable level of debt relative to their income, suggesting they are more likely to repay new loans.
- Higher DTI Ratios may signal that a borrower is overextended, increasing the risk of default.
- Economic Conditions Impact DTI Standards: In strong economic times, lenders may be more aggressive, allowing higher DTI ratios. During economic uncertainty or downturns, lenders tighten standards and may require lower DTIs to reduce risk.
Recent data indicates that high DTI ratios are associated with a greater incidence of mortgage default, even after controlling for other borrower and loan characteristics. (dallasfed.org)
Debt-Service Coverage Ratio (DSCR) assesses a property’s ability to generate enough income to cover its debt obligations. It’s calculated using the formula:
DSCR = Net Operating Income (NOI) / Total Debt Service
Where:
- Net Operating Income (NOI) is the property’s income after operating expenses.
- Total Debt Service includes all principal and interest payments on the loan.
For example, if a property generates an NOI of $125,000 annually and has annual debt obligations of $100,000, the DSCR is 1.25.
What Is an Acceptable DSCR?
- Traditional Banks: Typically require a DSCR of 1.25 or higher, meaning the property generates 25% more income than necessary to cover its debt obligations.
- Hard Money Lenders: May accept DSCRs as low as 1.0 in certain cases, especially if the property has strong appreciation potential.
Why DSCR Matters:
- A DSCR of 1.25 or higher indicates a healthy cash flow buffer, reducing the risk of default.
- A DSCR below 1.0 indicates negative cash flow, meaning the property’s income isn’t sufficient to cover its debt obligations, increasing the risk of default.
- Economic Conditions Impact DSCR Standards: In a booming real estate market, lenders may allow lower DSCRs, assuming rents and values will rise. In economic downturns, lenders may tighten DSCR requirements to ensure greater financial cushion.
Lenders use DSCR to evaluate the risk of default on a loan. A higher DSCR indicates lower risk, while a lower DSCR may signal higher risk. (trepp.com)
- Hard Money Lenders: Prioritize the value and potential of the property itself over the borrower’s personal financials. They assess the property’s after-repair value (ARV) and its ability to generate income.
- Traditional Banks: Emphasize the borrower’s personal financial stability, including income verification, credit history, and DTI ratios.
- Hard Money Lenders: Offer more flexibility in underwriting, often accommodating borrowers with higher DTI ratios or unconventional income sources, focusing on the property’s income potential.
- Traditional Banks: Adhere to strict underwriting guidelines, often requiring lower DTI ratios and stable income documentation.
- Hard Money Lenders: Provide faster loan approvals and funding, which is beneficial for investors needing quick access to capital.
- Traditional Banks: Typically have longer approval processes due to extensive documentation and stringent capacity assessments.
Assessing Capacity is vital in real estate lending, as it directly impacts a borrower’s ability to repay the loan and influences default rates. While traditional banks and hard money lenders both consider capacity, their approaches differ, with hard money lenders placing more emphasis on the property’s value and income potential.
Capacity requirements—DTI, DSCR, and overall risk assessment—change based on the economic climate. Lenders become more aggressive in favorable market conditions and more conservative when economic uncertainty arises.
At REI Transactional, we prioritize thorough capacity assessments to ensure our investments are secure and profitable. Our strong underwriting practices protect our investors’ capital and provide borrowers with the flexibility they need to succeed.
Ready to put your capital to work? Sign up for a call with us to discuss how we can help you achieve your investment goals.
Stay tuned for the final article in our Four C’s of Lending series, where we’ll discuss the fourth C: Capital—how lenders evaluate a borrower’s financial strength and investment in a project.
