We Need To Talk…About DSCR
“We need to talk”.
I know they’re not words you want to hear, but I promise this time it’s worth your while.
About what exactly? Nope, you’re not getting fired, and we’re not breaking up. Today, we’re talking about DSCR — or debt service coverage ratio and why it’s basically the Holy Grail of CRE metrics.
DSCR is a calculation used to see the cashflow of your property after you’ve removed all of your annual debts, but what you really need to know is that it’s important. Like really important, and it’s generally the first thing lenders look at in the borrowing process. Why? Because it can determine the structure of a loan. For example, if someone isn’t even close to the minimum DSCR they are looking for, then the lender will decline the loan right away. If someone has a DSCR that comes very close to the minimum DSCR amount, then a lender might cut back the total loan amount which will then require a larger down payment. This will increase the DSCR amount AND lower the LTV amount which will mitigate the risk in two ways. See what I mean? Important.
How Do You Calculate It?
To calculate the DSCR of a given property, you’ll take your Net Operating Income (NOI) (more on that here) and divide it by the total annual debt.
Typically, a CRE loan has a business listed as the primary borrower. So, in this case the annual debt includes all of the current year’s business debt obligations (or borrowers’ debts). This would include debts such as line of credit payments, minimum credit card payments, business lease payments or any type of business loan payment (this can even include business equipment loans). The most common mistake I see in calculating DSCR is not including all of the borrower’s debts. Some people only account for the loan payment but forget to include all other business debts, so be sure to keep an eye out for this.
In this case, let’s say you’re looking at a property with an NOI of $150,000 dollars and there’s a $10,000 dollar monthly payment. Over the course of the year (annual, or x12), that monthly payment would amount to a total Annual Debt of $120,000.
Divide the NOI by the total annual debt and that gives you a Debt Service Coverage Ratio of 1.25. So, what does that mean exactly? A DSCR of 1.25means that you have 1.25x the amount of cashflow on that property than you do debt (FYI, that’s good).
It’s important to note that preferences and requirements on what makes a ‘good’ or ‘bad’ DSCR value can vary from lender to lender. Generally, a lender will create a covenant saying that the property must have a “minimum DSCR of X” and then they track it through the life of the loan to ensure that the property is still making an adequate amount of money to make the loan payments. If the borrower doesn’t meet the minimum DSCR requirement at any point during review (typically tracked once per year at annual review) then the lender might start reviewing that loan more frequently (like every quarter, for example). Or, if this trend continues for long enough, they may possibly force the borrower to pay off the loan entirely.
While there is no ‘set range’, here’s generally how DSCR gets broken down:
No matter how ‘good’ the DSCR is at the outset, it always gets tracked throughout the year and here’s why: it fluctuates, and sometimes, a lot.
The DSCR value can change because the NOI can fluctuate, too, based on changes in things like vacancies and expenses. So, if your NOI decreases then your DSCR will decrease as well. Also, the total debts can increase as the borrower takes on more debt. If the borrower’s debts increase, then the DSCR will decrease.
Here Is What A Borrower Can Do To Work On Increasing Their DSCR:
- Increase their NOI by increasing their revenue (which they can do by raising the rent, for example).
- They can also decrease their expenses to increase NOI. For example, they can analyze their spending and cut down any unnecessary expenses.
- Lastly, they can pay off business debts. By paying off as much debt as possible it will decrease their overall total debt expense and in turn increase their DSCR.
We’ve established that DSCR is important, but today, it matters more than ever.
With market changes brought on the by the pandemic, we’re looking at a level of instability that makes lenders wary — and for good reason. In most cases (and pre-COVID), a ‘good’ DSCR value would be anywhere between 1.25 and 1.5. Today, you can expect that lenders are likely looking for DSCRs in a higher range than usual because of that volatility in the market. Raising the bar on DSCR helps lenders mitigate risk in uncertain times (like now) where expense rates and vacancies are higher than normal. As such, it’s extremely important for lenders to be able to consistently monitor the DSCR of a property with real-time data. This way, they can get the most accurate picture of performance possible and get ahead of unfavorable changes that may be coming.
And there you have it: DSCR. Hopefully this gives you a good overview of why it matters, how it’s calculated, and how to stay on top of it. Your takeaway for today? Keep your blood pressure down and your DSCR up! Doctor’s orders!
Until next time,
Still have questions? Drop me a note: firstname.lastname@example.org.