Rules of Thumb

While generally, I’m skeptical of “rules of thumb,” sometimes they do bear out as reasonable. Notably, most of the “rules of thumb” I use show the assumptions are generally correct after ample research and publications show a regression to a mean, or after years of work experience seem to also show a regression to a mean.

Real estate operating expenses tend to be an area where rules of thumb are particularly useful. You may have noticed or read that the operating expense for multifamily housing tends to start out at 30%-35% of gross revenue, and over time migrate to 40%-45%. For midscale hotels, that operating expense tends to be 70%. For full service hotels, the operating expense is generally 75%. If borrowers are using lower operating expenses, then in all likelihood they are underestimating the cost of operating the property.

Another interesting heuristic that comes to bear in the underwriting world is the debt-to-net worth ratio in Commercial/Industrial loans. Generally speaking, we don’t like to see debt-to-net worth greater than 3.00x for contractors or service providers, and we like to see the same ratio remain less than 1.50x for capital intensive industries.  Why do contractors differ from a capital intensive operation? A contractor’s balance sheet will be primarily receivables and payables, most of which will be satisfied within 30-90 days. Therefore, they can deleverage rapidly. However, when net worth is tied up in capital expenditures like equipment and machinery, those assets do not readily convert to cash to satisfy liabilities on the other side of the balance sheet. Therefore, their leverage is more permanent, suggesting we want to see less leverage from them overall.

Another rule of thumb in Commercial Real Estate lending has to do with leverage and collateral values. The less marketable real estate may be, the lower loan-to-value (LTV) you will find. For example, there is always a need for multifamily housing in a healthy community, so the property will always have interested investors. The LTV of these properties might be as acceptably high as 80%. Office and retail properties may be a bit less marketable, so we ratchet our LTV back to 75%. Perhaps industrial properties are even a little less marketable, because they come in an odd variety of shapes and inconsistent build-outs, so we take the LTV back to 70%. Then we have “special purpose properties,” which can only be used for narrowly specified purposes without significant investment to change those characteristics, like a medical office, private school, or restaurant. We may bring our LTV back to 65% in those cases.

Having these industry benchmarks in your back pocket makes you more powerful in the business lending world, because you can more quickly identify potential problems or get a grasp of the proper credit structure immediately. And of course, if a proposed loan does not conform rigidly to these rules, there may be a good reason to make an exception. However, there should be a strong mitigating reason to make an exception, as exceptions should not be granted simply to provide a reason to book the loan!