This article was posted on Sunday, Feb 01, 2015


Being a banker is a difficult post. If you lend out all your deposits there is no money left in the vault to honor normal withdrawal requests. If you don’t lend at all there is no income to provide for the bank’s operating expenses. The working solution is fractional banking, whereby the bank lends most, but not all deposits. The interest on these loans is expected to generate the funds necessary to stay in business, while the reserve (un-lent) funds are there to provide for typical withdrawals. 

Fractional Banking  

Fractional banking is a line-of-best-fit business. Nobody knows for sure how much money banks must keep available to honor withdrawal requests. But there are historical guidelines that the nation’s central bank employs that seem to work in most cases. In the USA, the fractional reserve requirement is currently 10% on most transactions.

Fractional banking means deposits are only partially reserved for. The bank keeps a fraction of your deposit as reserves. Briefly, this is how it works. It’s the first of the month and Ursula Underwriter picks up her too-large purse and treks to the bank to deposit her paycheck. Being a plain woman with crossed eyes, fond of sensible shoes and used to getting her way, she long ago concluded that the single life was best even if that meant she’d have to provide for her own retirement. 

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The Good                              

Before placing any money in her checking account, Ursula deposited $1,000 into retirement savings. She read somewhere that she should pay herself first, and that appealed to her sense of appropriateness. Once deposited, the bank must reserve a portion – assume 10% — but can then lend out the remaining $900. If the bank pays Ursula 1% annual interest ($10 on $1,000) but earns 4% ($36 on the unreserved $900) all is well. Ursula is happy, the bank’s overhead is assured and there’s something left over for shareholder profit. It’s a good day at the bank. 

The Bad                                

Sometimes, however, things go poorly and the $900 is not repaid. Not only does Ursula’s $10 interest have to come from other bank assets, but so does the $1,000 she deposited. Only $100 was reserved, so there is a net loss to the bank of $900. Regulators do not approve of losses, so banks constantly adjust their lending standards to accommodate their bureaucratic overlords. 

Proving Income                    

The important forms in a complete loan package functionally correspond to the accounting statements found in a company’s annual report. The accounting statements reveal important data about a business, data an investor would want to know before buying shares. Similarly, the loan package reveals necessary data about an individual that a lender would want to know before committing to a loan. In either case, the first question is “How much does this guy make?” That question is addressed with the business’s audited Income Statement, which begins with gross sales and incrementally deducts the costs of earning those sales until the infamous “bottom line” reveals the business’s net income for that period. The Income Statement for a business is equivalent to the tax returns for the individual. The 1040 helps to establish the individual’s income for the period. 

Establishing Assets               

The Balance Sheet lists assets on one side and liabilities on the other. If you subtract assets from liabilities you have the entity’s net worth.  For the individual borrower, the lender asks that the standard loan application (Form 1003) be completed. This shows whether or not the loan can be repaid from other assets if the borrower loses his job.

For the individual, a current pay stub showing the applicant is employed, the Income Statement equivalent (tax returns) and the Balance Sheet equivalent (Form 1003) used to be pretty much it. I mean, if the person has a job, earns enough to make the necessary payments and has assets to repay the loan if he gets laid off, what more do you need? Quite a bit, as it turns out.

Regulations now require, in addition to the above, that most lenders establish that the borrower has the reasonable ability to repay the proposed loan as agreed. It used to be that ability to repay was assumed through the tax returns and 1003 (loan application). Now it’s got to be demonstrated, so that’s the new overlay: demonstratedability to repay. This is where the Statement of Cash Flow joins us at the table. 

Ability to Repay                   

The Statement of Cash Flow reveals a business’s change in cash flow at the end of the year. The top line of the Statement of Cash Flow is the same as the bottom line of the Income Statement. Then adjustments are made, both additions and subtractions, to better reflect the cash position of the business. For example, the classic “depreciation” deduction on the Income Statement is a non-cash reduction in reportable income. The apartment owner did not actually write a check to pay for the depreciation taken, but “depreciation” can be taken anyway because the government says so. Depreciation is sort of a phantom loss, so to better reflect the actual flow of money it’s added back into the Statement of Cash Flow.

It’s possible for a business to earn an accounting income (shown on the Income Statement) but still not be able to pay its bills due to expenses being greater than actual income. For a business, the dollars (if any) available after paying its bills are reflected in the Statement of Cash Flow.

There is no private accounting statement equivalent to the Statement of Cash Flow, so it has to be computed by the lender, and each lender does it a little differently. The basic format is similar to the decision tree that a bank uses to determine if a building will support a particular mortgage payment. Remember? That’s the one that starts with Gross Scheduled Income, pauses briefly at Net Operating Income, then deducts principal and interest payments and concludes at “cash flow”. We’ve gone over that format many times, but it never hurts to review. 

The Building Qualifies         

The individual apartment investor has for a long time had to establish to the lender’s satisfaction that the payments on the new apartment loan could be serviced with the dollars remaining after fixed and variable expenses are paid. “The building has to pay for itself”. Of course, you remember how the building qualifies in that way: it’s through the Debt Coverage Ratio (DCR), and the formula is NOI divided by DCR equals maximum loan payment.

Ex: $12,000 monthly NOI divided by 1.25 DCR = $9,600 available for debt service. How much loan that payment would support will be affected by the interest rate: the lower the rate, the more money you could borrow and still keep the payment at $9,600. And of course, that means that regardless of the amount borrowed, the net cash flow (in this example) would remain at $2,400 monthly ($12,000 minus $9,600).

That is how the building qualifies for the mortgage, and for a very long time that was where it ended for apartment loans of 5 units or more. “Did his tax returns come in, David?” Check. “How about his pay stubs?” Yep. Those, too. And we got the 1003. “Ok. How’s the DCR?” Covered, barely. “Great. Fund the loan and we’ll go to lunch. It’s your turn to buy.” 

The Borrower Qualifies       

Even with all the above, lenders still experience losses. So now it’s not just the building, but in most cases also the borrower who has to qualify for the new mortgage on income real estate. The way that’s done is through a Global Cash Flow (GCF) analysis, which shows whether a borrower, in the bank’s estimation, can comfortably handle all of his obligations. Global Cash Flow is determined by dividing the borrower’s total income by his obligatory payments (both contractual and discretionary). The result must meet or surpass a hurdle figure (hypothetically, 1.25).     Example        Total income = $10,000. Obligatory payments = $8,000.  $10,000 divided by $8,000 equals 1.25. He’s ok where he is, but can’t refinance if it’ll raise his payments.

Or you could add all obligatory payments and just multiply by 1.25. That gives the necessary income to support those payments. Example    $8,000 x 1.25 = $10,000.

The Global Cash Flow analysis is performed using a Debt to Income (DTI) ratio much like the Debt Coverage Ratio analysis is performed on the building. Both the building and (now) the investor must pass these minimum thresholds to be eligible for the loan.                                   


A building qualifies for a loan if the payments do not exceed Net Operating Income divided by 1.25. (Another way of saying it is that the building’s mortgage payment cannot exceed 80% of the NOI.)

A borrower qualifies for a loan if his Global Cash Flow exceeds his obligations by 25%. (Another way of saying this is that the borrower’s obligations cannot exceed 80% of his after-tax income.) 

Passing the Global Cash Flow filter requires that a borrower’s income exceeds expenses (contractual and discretionary) by a certain percentage. Note that figure varies among the different banks but is not an arbitrary dollar amount; it is a percentage of gross income. 

GCF Example                                  

To kind of flesh out Global Cash Flow, let’s say Phillip’s gross monthly income is $15,000. Obviously, all of that is not available for discretionary spending. First, he has to reserve for federal and state taxes, say $3,500. Then all the other deductions are subtracted, perhaps another $1,500. That leaves him with $10,000.  

Gross Salary:            $15,000

Less: Taxes:                 -3,500

Less: Deductions:       -1,500

Net Salary:               $10,000 

But Phillip owns his home and the monthly PITI comes to $3,000. The car payments come to $1,000. Then there are discretionary expenses for his wife ($2,000) and two children ($1,000 each). These figures vary between lenders. Some banks debit $3,000 for the wife and another $3,000 for each child. 

Net Salary:                  $10,000          

Less: PITI:                    -3,000

Less: Car Payment:       -1,000

Less: Dependents:         -4,000

Global Cash Flow        $2,000 

Since we know the debts, our task is to discover the minimum take-home pay required (for banking purposes) to service those debts. Debt to Income (DTI), in this example, is required to be 1.25 or more (various banks have slightly different DTI requirements). Phillip’s fixed and variable costs (after taxes) are $8,000. The math is elementary. We multiply Phillip’s obligations by the Debt to Income (DTI) ratio of 1.25:  $8,000 times 1.25 DCR = $10,000 minimum take-home pay.

Sometimes it’s easier to go the other way. If we know a prospective borrower’s after tax income, we can divide by 1.25 to determine the maximum debt load. For example, $10,000 take-home divided by 1.25 means monthly obligations cannot exceed $8,000.  

Phillip’s Alternatives            

Phillip does not qualify for a loan that will increase his payment burden (and drop his Global Cash Flow below the bank’s minimum). But he certainly is a candidate for a refinance that would decrease his payments and consequently increase his Global Cash Flow. As long as his GCF after the refinance stays above the required minimum, Phillip can continue borrowing and buying.

Should Phillip elect to refinance his home (thereby reducing his payments and at the same time increasing his GCF) and use the proceeds to buy an apartment building, his Global Cash Flow would surely be sufficient. 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]

If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book Stairway to Wealth available at