Debt Coverage Ratio

In Episode 76 of the Investing with GoodLife podcast, Rohan and David discuss a term frequently used by lenders and institutional investors, Debt Coverage Ratio or Debt Service Coverage Ratio (DSCR). Rohan and David define the Debt Coverage Ratio and discuss specifically how it impacts them through their work at GoodLife Housing Partners.

Read on to learn more or you can listen to the episode using the following link. Investing with GoodLife is available on all major podcast platforms.

Defining DCR
Debt Coverage Ratio is used in a number of ways. As a formula, it’s your Net Operating Income (NOI), (Listen to Episode 73 to learn about NOI) divided by the Annual Debt Service (all the payments you have to make as a borrower under the loan).

If your NOI is the same as what you have to pay the lender for your loan for the coming year, then you’re basically at a 1.0 Debt Service Coverage Ratio (DSCR). If this is the case, you won’t have much room for movement as all of your revenue from your investment will basically be used to pay your loan costs. If your loan revenues decrease or your expenses increase, you will not have enough funds generated from the asset to pay your monthly loan payment.

In last week’s podcast episode, Rohan and David discussed Loan to Value, which is another metric lenders use to size up the amount of loan proceeds they’ll give you. Once you get past Loan to Value (LTV), the next step in the lenders underwriting in determining your maximum loan proceeds is Debt Service Coverage Ratio (DCR or DSCR).

Understanding Lender’s Relationship with DCR

To understand how DCR affects lender’s calculations, a lender doesn’t want you to use 100% of the net operating income for your loan payments because if for some reason the net operating income goes down then the lender is exposed to financial risk. Lenders of course don’t want any risk, for the DSCR, lenders have a test they call the DSCR test. Lenders like to see a DCR number of 1.2 or higher. This means the revenue that you generate from a property is at least 1.2 times more than what you have to pay monthly on annually in debt service to the lender.

DCR or DSCR follows the same idea as LTV. It is an opportunity for professional investors to push returns, by getting higher leverage and to push the best DCR down. It’s important to remember that as an investor you must also have some cushion and be responsible, especially when things can get a little choppy. Having very high leverage amounts or a very low Debt Coverage Ratio can lead to some challenges or problems if cash performance at the asset declines.

What does it mean if your ratio is below one?

If your ratio is below one, that essentially means you’re negative. From the revenue you’re collecting on your real estate asset, you’re not gaining enough money to cover your loan payments. This ultimately becomes a problem because then someone has to fund capital to make those loan payments or else you will be in default. You might have to make a Capital Call to your investors as a result (which nobody really wants to do). It is very awkward to go back to investors to say, “Hey, the property is not generating as much income as I thought, I need more from you before the lender gets mad at me”. The worst-case scenario is the lender then forecloses on you and you wipe out you and your investor’s entire cash investment in the real estate.

How GoodLife HP Thinks about DSCR

At GoodLife Housing Partners, when we look at investments, we are mindful of the DSCR. The lender looks at DSCR to figure out what kind of risk they will take. We need to look at it and figure out what kind of cushion or margin of effort do we want?

When we typically do value add transactions, we’re renovating apartments and other units so the cash flow will typically dip due to vacancies while renovating a unit. It is extremely important to be mindful that you’re not put in an awkward position where you can’t cover your loan. Lenders don’t want to own the real estate also so that’s why when they size loans so they can figure out what’s the maximum they’ll give you in terms of loan proceeds. They look at Loan to Value and they also look at DSCR.

Overall, the Debt Coverage Ratio is a simple metric to explain or demonstrate how risky your project may be.

How Do Lenders Use Debt Service Coverage Ratio (DSCR)?

Lenders use Debt Service Coverage Ratio to also determine what the DSCR will be later on after your business plans are completed. For example, once you execute your business plans and the renovation plan is completed, and you know how rents will look like in the future, lenders want to make sure the new revenue is healthy enough that there can be a takeout lender who will be able to refinance you and pay off the current existing lender. The pay-off lender will be looking at the DCR once again to figure out how the property’s net revenues can cover the new loan payment.

In our business at GLHP, they check to see if we raised the income and make sure everything was verified.

The lender will look at the DCR and say something along the lines of, “Well on stabilization after your business plan is done, it looks like your Debt Service Coverage Ratio will be super healthy (1.3 or 1.4)”

If the lender believes the business plan is realistic and feels like you’re capable, and have the track record and skills to execute, then the lenders will get comfortable with that risk and they’ll do that loan. If you get to 1.3 or 1.4 DSCR in the future, lenders know there’ll be a market for other lenders to basically refinance them out and so again, it’s a measure of risk and the pressure of where the revenues are currently versus where it needs to get to be in the future.

Moving Forward with DCR/DSCR

Ultimately in the commercial real estate business, DCR/DSCR is a good metric to use in your own analysis. A bank will always put your deal through this matrix. Having good knowledge of what that number is and how to calculate it is useful wherever you’re investing. Additionally, when you’re choosing lenders, whoever you pick as a lender it’s good to know what their tests and risk tolerance is.