By Jack Jerue One of the most appealing aspects of real estate investing is the…
By Brendan Hamilton
There are many different acronyms used in commercial real estate finance on a frequent basis. For newer investors or borrowers, some of these may sound foreign and require additional explanation. One of the most asked about terms is DSCR. We will explore this term in the next few paragraphs. DSCR is critical to real estate investing and is considered by almost every lender when reviewing deals.
What Is DSCR?
DSCR stands for the debt-service-coverage ratio, a highly scrutinized metric often used to underwrite long-term financing. It helps lenders determine if certain assets qualify for a commercial mortgage. DSCR is a calculation that tests a property’s (or portfolio of properties), ability to service the debt. In other words, it tests the property’s ability to make principal and interest payments from its income. From a mathematical perspective, DSCR is the ratio of income generated for every $1 owed to the lender. So, a 1.30x DSCR would mean that the assets generate $1.30 for every $1 that is owed to the lender.
For example, when CoreVest is underwriting a loan, the DSCR gives us an indication on whether the borrower is generating enough income and is also keeping expenses low enough to continue to make principal and interest payments. A 1.00x DSCR would mean that the deal has enough income to pay for all expenses and pay for the loan but the investor would not be making any money and has no wiggle room based solely on the cashflow. (Of course, there are also other factors such as appreciation.)
At 1.00x DSCR, the income would entirely be going towards expenses and principal and interest payments. Any drop in income or increase in expenses would cause the borrower to make payments out of pocket. If a tenant stopped making payments, suddenly moved out, or the property needed heavy repairs, the borrower would not have the excess income from the properties to deal with this sudden change. In general, a DSCR greater than 1.00x is referred to as a positive DSCR, and one below 1.00x is considered a negative DSCR.
How is DSCR Calculated?
DSCR is calculated by taking the NOI (Net Operating Income) and dividing it by the Debt Service. For basic numbers sake, if a portfolio of single family rentals had an NOI of $136,000, and the annual principal and interest payments were $100,000, then the portfolio would have a 1.36x DSCR ($136,000/$100,000). Many real estate lenders have a DSCR requirement between 1.15-1.25x.
One component of this formula that often causes confusion or disagreement, is the calculation of NOI. Note that it is important to factor in assumptions that most lenders will make when calculating NOI, rather than applying only actual expenses. For example, during the last 12 months maintenance and repairs may have been extremely minimal, but on a go forward basis, there may be some historical indication that assets will need upkeep to hold value, increasing the expenses.
Another example of a DCSR nuance would be calculating vacancy. Even if a rental portfolio is 100% occupied at the time of underwriting the loan, it will likely not have 100% occupancy for the entirety of this term, whether it be 5, 10 or 30 years. Most lenders will use a 5-10% vacancy factor to underwrite these loans to account for this.
Property management is another assumption that often creates variance in the DSCR that is calculated by the investor versus the one generated by the lender. Even when properties are self-managed, lenders may still apply a 4-8% property management assumption for cushion in the event the assets must be foreclosed upon, for example.
Overall, it is important to remember to look at the calculations discussed above as a lender would, especially if growth and leverage is in the pipeline.
Who Uses DSCR?
Commercial loans are more interested in the cash flow of properties, which is why commercial lenders, such as CoreVest, use the DSCR calculation. Residential mortgage providers typically look at a slightly different figure called DTI (Debt to Income ratio). DTI is more of an all-encompassing look at the borrower’s debt versus their income, while the DSCR calculation looks at the assets’ cash flow.
A strong, positive DSCR will provide more options for the borrower when looking for a loan, but it also provides some relief during the life of a loan. If a loan falls below a certain DSCR threshold, it could trigger events in the form of cash management. It is extremely useful to continue to run these calculations throughout the investment lifecycle whenever there are changes to expenses or income.