What is the lower-of rule in commercial underwriting?

The lower-of rule means the maximum loan amount is the smaller of the LTV-based amount and the DSCR-based amount. In the worked example, the LTV limit was $937,500 and the DSCR limit was $1,035,000, so the loan is $937,500. The rule applies to every commercial loan, regardless of lender type.

Why does the cap rate produce a property value, not a loan amount?

The cap rate gives the property's market value based on its income. The loan amount is a percentage of that value, set by the LTV ratio. The cap rate is the starting point, not the answer. You need both the cap rate and the LTV to size the loan from the property side.

What is the actual/360 surprise and how do I avoid it?

Actual/360 charges interest on the actual days in the month divided by 360, which adds 0.5 to 1.0 percent to the effective rate. Avoid it by calculating your payment using the actual/360 factor from the start. Do not use a 30/360 calculator for a commercial loan.

What is the minimum DSCR for a commercial loan?

Published agency minimums are 1.25x, but lenders underwrite to 1.30x to 1.35x in practice. The real gap is 0.05x to 0.10x. A 1.20x deal has zero cushion for vacancy or expense creep. Always stress-test at 1.35x to see if the deal still works.

What happens if the balloon comes due and the property value has dropped?

If the property value drops 10 percent, the LTV on a $937,500 loan climbs to 83 percent. The lender may refuse to refinance. That is the balloon refinance failure. The way to avoid it is to stress-test the deal at a 75 percent LTV and a 1.40x DSCR before you sign.

What is the debt yield floor and why does it matter?

Debt yield is NOI divided by loan amount, expressed as a percentage. CMBS lenders require a minimum of 10 percent, regardless of the interest rate. A deal with a 1.30x DSCR but a 9.5 percent debt yield fails. Debt yield ignores interest rates, so a low-rate loan can still fail the test.

What is the most common mistake borrowers make with this calculation?

The DSCR miscalculation: using gross rents instead of net operating income after vacancy and expenses. The real DSCR ends up at 0.95x, not the 1.20x the borrower calculated. Always use NOI, not gross income, and always include a 5 to 10 percent vacancy allowance.

From Property Value and Cap Rate to a Loan Stress Test

You need to know how much debt a commercial building can support. The path from property value and cap rate to a loan stress test is the only way to answer that without guessing. The exact calculation, the real stress test, and the one failure case that sinks most first-time borrowers.

Start with the property's yield. The cap rate gives you that: it is Net Operating Income divided by property value, expressed as a percentage. If a building generates $100,000 in NOI and the market cap rate is 8%, the property is worth $1,250,000. That is your value anchor. From there, you size the loan two ways and take the lower number.

A Worked Example

Work a concrete deal. NOI is $100,000. The market cap rate for this property type and location is 8%. Property value equals $100,000 divided by 0.08, or $1,250,000. A lender offering 75% LTV caps the loan at $937,500.

Now run the DSCR side. The lender sets a minimum DSCR of 1.25x. Maximum annual debt service is $100,000 divided by 1.25, which is $80,000. That means the maximum monthly payment is $6,666.67. For a 25-year amortization at 6% on an actual/360 basis, the payment per $1,000 borrowed is approximately $6.44. Divide $6,666.67 by $6.44 per $1,000, then multiply by $1,000. The result is about $1,035,000.

The lower of $937,500 and $1,035,000 is $937,500. That is the maximum loan this building supports. The cap rate calculator tells you the property value; the DSCR test tells you what the cash flow can carry. The lower-of rule is the connection between property yield and debt capacity.

Calculation Steps

The calculation has three steps and one trap. Step one: derive property value from NOI and cap rate. Step two: apply the LTV ratio to get a loan amount. Step three: derive a second loan amount from the DSCR limit, using the actual amortization schedule and interest rate. The lower of the two is your answer.

The trap is the actual/360 interest accrual. Every commercial note uses actual/360, which charges interest on the actual number of days in the month divided by 360. That adds 0.5 to 1.0 percent to the effective rate compared to a 30/360 calculation. On a $937,500 loan at 6%, the difference is roughly $10 to $15 per $100,000 borrowed per month. If you calculate the payment on a 30/360 basis, you will see a payment 0.5 to 1.0 percent higher on the closing statement. That is the actual/360 surprise, and it is why you must use the correct daily factor from the start.

Do not use gross rents for NOI. Use net operating income after a 5 to 10 percent vacancy allowance and a 30 to 40 percent expense ratio. A borrower who uses gross rents instead of NOI gets a DSCR of 0.95x, not the 1.20x they thought, and the loan does not close.

Why the Method Works

The connection between property yield and debt is not a single formula. It is a two-sided test. The cap rate side says what the building is worth. The DSCR side says what the building can pay. The loan is the intersection of those two limits, and the stress test is what happens when the assumptions change.

Run the stress test with a 10 percent NOI decline. If NOI drops to $80,000, the maximum annual debt service at 1.25x DSCR is $64,000. But the actual annual payment on a $937,500 loan at 6% is still $80,000. The DSCR becomes 1.00x, below the 1.25x minimum. That is the failure case: a loan that passes at closing fails the first time the property has a bad year.

Also stress the interest rate. If rates rise 200 basis points, the payment per $1,000 borrowed increases. The same $937,500 loan at 8% has a higher monthly payment, and the DSCR drops further. A deal that barely passes at 6% fails at 8%. The lender's underwriting to a 1.30x or 1.35x DSCR in practice absorbs some of this, but not all of it. The borrower who does not stress-test both NOI and rate is the borrower who loses the building at the balloon maturity.

The One Failure Case That Sinks The Deal

The single most common failure is the borrower who runs the calculation once and stops. They get the $937,500 loan amount, sign the note, and never model what happens if NOI drops or rates rise. The stress test is not optional. Run it with a 10 percent NOI decline and a 200 basis point rate increase. If the DSCR drops below 1.25x in either scenario, the loan is too large.

If the DSCR drops below 1.00x, the property cannot pay its debt. The lender does not care about your personal credit score; the underwriting focuses on the property's cash flow. A residential borrower who assumes this works like a 30-year fixed mortgage is in the wrong place. This is commercial debt, secured by the building's income, and the building must support itself.

That is the honest caveat. The calculation shows you what the property can support under ideal conditions. The stress test shows you what happens when conditions are not ideal. The borrower who ignores the stress test is the borrower who loses the building.