Value, Value, Value: It Trumps Location When You Go Mortgage Shopping
Dec. 18, 2015 —
Though interest rates have just jumped, your building needs a major capital improvement and your co-op board has decided that the best way to pay for it is to re-finance your underlying mortgage. Before you go mortgage shopping, you need to understand a bit of jargon known as your LTV – your loan-to-value ratio.
This ratio is almost always expressed as a percentage, which is calculated by dividing the proposed new loan by the estimated value of your property. Most lenders limit their loans to a maximum LTV of 75 percent.
Simple enough. However, problems arise because borrowers and lenders tend to view a property’s value from sharply different perspectives. When most co-op shareholders think of their building’s value, they multiply recent apartment sales prices by the number of units in the building. In a hypothetical nine-unit co-op where apartments are selling for about $325,000, this method would peg the building’s value at $2,925,000. The maximum loan, based on the LTV, would be $2,193,750, roughly $2.2 million.
Alas, lenders see things differently. Their biggest fear is that a borrower will not make the monthly payment, forcing the property into foreclosure. Since lenders do not want to own property – they’re lenders, after all, not landlords – whenever they acquire a property through foreclosure, they almost always put it up for sale.
So when a lender thinks about value, he or she doesn’t care about recent sales prices or what the shareholders paid for their apartments. From the lender’s perspective, a property’s value is the price it will fetch in a quick foreclosure sale. And that price is difficult to determine, especially for a cooperative apartment building.
Let’s look through a lender’s eyes. If the hypothetical nine-unit co-op defaults on its loan and goes into foreclosure, the lender imagines the building winding up as a rental property. Say each of the nine apartments would rent for $3,000 a month, based on neighborhood prices. That means the maximum gross income for the building would be $324,000 a year. Most lenders will reduce that number by about 5 percent to account for vacancies, tenant moves and market slumps, bringing the adjusted gross income to $307,800.
Let’s say the co-op’s operating expenses were $170,000 a year. Most lenders will factor in a 6 percent increase in various line items (real estate taxes, heating fuel), plus an increase in insurance coverage, a full-time management fee, and at least $1,000 per unit for maintenance, repairs and replacements. After these adjustments, the operating expenses will rise to $204,590. The lender will deduct that amount from the adjusted gross income and come up with a net operating income of just $103,210.
This number represents the annual cash flow an investor would receive if he buys the building with cash. If the investor wanted an annual 7 percent return on his investment, he would divide the net operating income of $103,210 by .07 and arrive at a value of $1,474,429.
If you then apply the standard maximum LTV rate of 75 percent, the most the lender will be willing to lend to the nine-unit co-op is $1,105,821.
That’s not nothing, but it’s about half of the $2.2 million loan the shareholders had hoped for, based on what they thought their building was worth. That’s why borrowers need to understand the LTV – and, especially, how lenders calculate value.