Final answer:
To calculate the maximum sized loan for a property with an NOI of $1 million and 7% cap rate, we use the required DSCR of 1.25 and a 20-year amortization period with a 6.75% interest to find that the annual debt service cannot exceed $800,000. The actual loan amount will be lower than the loan-to-value indication due to DSCR constraints.
Step-by-step explanation:
To determine the maximum sized loan the lender will issue, we need to calculate the debt service coverage ratio (DSCR) and apply the cap rate to the expected first-year net operating income (NOI). Using the given 7% cap rate and an expected first-year NOI of $1 million, the appraised property value is $14.285 million ($1,000,000 / 0.07). The lender offers up to 70% financing on the appraised value, which amounts to $10 million ($14.285 million x 0.70). However, the minimum DSCR required by the lender is 1.25.
The annual debt service can be calculated using the amortizing loan formula applied to a 20-year mortgage with a 6.75% interest rate and monthly payments. Using these variables, the annual debt service must not exceed $800,000 ($1,000,000 / 1.25), to meet the DSCR of 1.25.
To find the annual debt service on the loan, we divide the annual NOI by the DSCR ($1,000,000 / 1.25 = $800,000). With an interest rate of 6.75% and 20-year amortization, we can plug these figures into a financial calculator or an appropriate software to get the maximum loan payment the borrower can afford annually. Finally, this annual debt service is used to calculate the maximum loan amount, which turns out to be lower than the $10 million initially indicated by the loan-to-value ratio due to DSCR constraints.