One of the most essential concepts in real estate investing is leverage. Leverage is the capacity for someone (or a team of people, such as a sponsor or development group) to finance a considerable part of the property’s purchase and/or redevelopment costs.
Differing from stocks, bonds, and other equity investments that require an individual to pay face value, investors can use leverage to lower their up-front and out-of-pocket expenditures. For example, if someone buys a $1 million property, they might finance $750,000 using a traditional bank loan. This leverage caps their out-of-pocket expenses to $250,000 – a considerably lower barrier to overcome than needing to pay $1 million privately.
However, getting a loan of this size (or more) can be difficult. This is because lenders will typically look at the borrower’s personal earnings, the value of their assets, and the parcel’s income-generating potential.
When assessing whether or not to make a loan, lenders will use a “debt service coverage ratio” metric to determine the latter—i.e., the property’s income-generating potential. In this piece, we look at the significance of DSCR and how investors can use this metric to mitigate their risk.
What is the Debt Service Coverage Ratio (DSCR)?
A debt service coverage ratio (DSCR) is a key metric used by lenders to determine the ability of a property to repay its debts. The ratio measures how much cash flow is available to cover mortgage payments, taxes, and other debt obligations. To calculate the DSCR, you need to know the total Debt Service (mortgage payment + other debt payments) and the net operating income (NOI).
The higher the DSCR, the more likely that a property can repay its debts. Lenders will typically require a DSCR of 1.25 or higher for non-owner-occupied properties.
If the ratio falls below 1.25, it may signify that the company is struggling to meet its obligations. As a result, Properties with a low DSCR may be less desirable to investors and property managers. Understanding the DSCR can help you make more informed decisions about your investments.
Furthermore, an asset with a DSCR of less than 1.0 is considered losing money, and chances are, it won’t have enough income to cover debt payments. From a lender’s perspective, the higher the DSCR, the better.
The DSCR ratio is used concurrently with the loan-to-value (LTV) calculation. As a result, properties with a higher LTV ratio may have a lower DSCR ratio and vice versa. Therefore, to meet a lender’s favored DSCR ratio, a borrower may have to put more equity into the deal to reduce the LTV. Ultimately, this is one of the primary routes lenders mitigate the risk of borrower default.
How to Calculate the Debt Service Coverage Ratio
The debt service coverage ratio is as follows:
DSCR = Net Operating Income (NOI) / Debt Obligations
For this computation to be accurate, the borrower needs to grasp the property’s NOI.
The NOI tots up all rental income plus other amenity income (e.g., parking fees, car wash income, storage fees, laundry or vending machine income, billboard/signage fees, valet trash income, etc.) Occupancy losses and all operating costs (including property taxes, maintenance, and management fees) are then deducted from that sum to determine the NOI.
NOI = Total Income – Total Operating Expenses and Vacancy Losses
Debt obligations are more common. Basically, like a mortgage, it is the principal and interest payment owed to the lender each month. A lender’s DSCR tally might also include property taxes and insurance. If these are added in as debt obligations, they should not be considered into the operating expenses when figuring total NOI. They should only be accounted for onetime on either side of the DSCR equation.
I.e., let’s say a self-storage facility has an NOI of $3.0M and an annual debt service of $2.2M. In this case, the DSCR would be:
$3.0M / $2.2M = 1.36x DSCR
Most lenders desire to see a DSCR in the range of between 1.25x and 1.50x. so the above is pretty strong. From a lender’s point of view, the higher the DSCR, the better, basically this signals that there's more income readily available to cover debt obligations.
The Importance of DSCR
DSCR is paramount to any borrower interested in securing a loan to purchase, renovate or refinance a commercial property. This is valid regardless of product type (i.e., multifamily, office, hospitality, retail, self-storage, and the like). Some lenders may be inclined to originate a loan founded solely on a borrower’s income, credit, and the value of their assets. Most, however, will also look at the portion of the revenue generated by the property and if that is adequate enough to cover debt obligations.
The key to a successful loan is how much you make and whether or when it will be paid back. This is typically true among asset-based lenders, who nearly exclusively rely on DSCR to ascertain if borrowers qualify for a specific loan amount. The more income an asset yields compared to its debt service obligations, the greater the likelihood of loan repayment. For this reason, banks and credit unions predominantly rely on DSCR (debt service coverage ratio) as one factor in determining if someone can get their hands on some money from these fine institutions!
Most lenders favor DSCRs of at least 1.25 to 1.50x. This implies that the property generates 1.25 to 1.50x the revenue required to cover debt payments.
With an ample DSCR, a borrower may be able to close a loan based on the strength of a relationship at advantageous terms regardless of their personal income or credit history. It truly is all about the deal!
Beyond financing, DSCR can be a helpful tool for those looking to conduct a quick, side-by-side breakdown of different investment opportunities. While DSCR is only one method to use, it does deliver a fast, easy-to-understand snapshot of a project’s potential profitability.
Using DSCR to Increase Profitability
DSCR can prove to shed much light for investors. For example, look at the in-place NOI and debt service and then, understand the DSCR to be low, may use this as a flag to identify cost savings. Let's say, an investor may find that in-place rents are below the market average. If they can affect a rent rate increase, which is possible in today’s market, can increase the DSCR calculation.
Likewise, a property manager may find that their operating expenses are above average. This could be what an owner needs to make property improvements that lead to greater efficiencies or bring on vendors that increase NOI.
As you might suspect, a property’s DSCR can fluctuate over time. This is because the calculation relies on a snapshot in time; the inputs to that calculation may vary from year to year as leases renew, resident rollover, property improvements are made, etc. Assuming a property’s DSCR substantially grows with time, it may be worth refinancing the current loan into a new loan with a lower rate and /or better terms since lenders will see the deal more appealing as the DSCR grows.
Collectively, any modifications a lessor makes to enhance the DSCR will result in greater profitability for investors.
Conclusion
The DSCR is an essential metric for any company owner interested in obtaining a loan – real estate-related or otherwise. The loftier the going-in DSCR and the taller the projected DSCR after property improvements, the less risk associated with debt repayment. Deals with smaller risks will naturally qualify for better rates and terms among commercial lenders.
By comprehending a property’s DSCR, investors can make more educated decisions about property improvements, operations, and financing options – conclusions that will eventually impact a project’s total cash flow, and by extension, the returns investors might anticipate.