Don’t Get Caught Flat-Footed When It Comes to the Debt Service Coverage Ratio (DSCR)Brian Hansen
What the Debt Service Coverage Ratio Means for You and Your Loan
Across the country, the commercial multifamily market has seen incredible increases in values. Investors are flocking to the opportunities and returns that are possible through multifamily investing. Forbes predicts slow and steady growth for commercial real estate well into 2018 and beyond as investors ride the waves of the long period of economic recovery following the 2008 recession.
As demand from buyers looking to gain entry into multifamily investing or growing their portfolios continues to increase, capitalization (cap) rates are being forced down. This means that debt service coverage ratio (DSCR) calculations are more important than ever in determining loan amounts. As property values continue to rise—and rent increases lag—the DSCR will emerge as the primary limiting factor before the full loan to value (LTV) is achieved.
Although some borrowers see the DSCR as a restraint to reaching maximum leverage, and thus, higher loan amounts, it is also a failsafe for the investor because it ensures mandatory loan payments can be made from standard monthly cash flow. Maintaining a high DSCR reduces risk to the lender—and the borrower. The last thing any responsible lender will do is to put the sponsor in a position where the property can’t sustain itself.
Understanding your DSCR and how it affects your maximum loan amount puts you one step ahead of other potential borrowers. After reading this post, you’ll be able to calculate the maximum loan amount based on the DSCR.
What DSCR, NOI, and LTV have to do with you and your loan
Let’s begin by breaking down DSCR. You arrive at your DSCR by taking your net operating income (NOI) and dividing it by your annual principal and interest payment—or for simplicity’s sake, your debt payment. For example:
DSCR 1.25 = $125,000 NOI / $100,000 Annual Principal & Interest Payment
In this example, your NOI can cover your annualized debt payment 1.5 times. This gives you ample leeway in case you run into unexpected expenses or vacancies. A property that has a 1.0 DSCR makes only enough to cover the annual debt payment. What a lender sees from a 1.0 DSCR is: no profit to the sponsor and no buffer for the mortgage payment. This is a big problem.
A lender will take the DSCR and compare it to the LTV to qualify a borrower. If a loan program allows a 75% LTV, there is inevitably a corresponding minimum DSCR that must be met. In many cases that minimum is a 1.25 DSCR. You can only achieve the full 75% LTV if the loan underwrites to a minimum DSCR of 1.25.
Let’s say at 75% LTV, your DSCR comes in at 1.21. The DSCR becomes the limiting factor, and you will have to reduce the loan amount by coming up to the 1.25 DSCR. In this case, your maximum leverage will end up being 70–72% LTV.
Once you know your NOI and the DSCR, you can calculate your maximum loan amount. To do this, you’ll need a financial calculator, do a web search for a free financial calculator, or you can download an app. (Pro tip: for Apple, the EZ Financial Calculators app is great. For Android or desktop, try this online financial calculator.)
Divide the NOI by the DSCR, then divide that by 12 to get your maximum monthly principal and interest payment. Now enter that payment amount into the TVM Calculator in either app. Then input the interest rate, and enter the number of months in the period line. Solve for the present value and that’s your maximum loan amount.
If your DSCR and maximum loan amount are where they should be to apply for the loan program you want, you can approach lenders with confidence and have a more meaningful conversation about the loan you’d like to qualify for. But is there anything you can do if your calculations leave you in limbo? Let’s learn how you can position yourself for your next investment.
Do you want to move the needle for your next Refi?
Do you want to get more leverage? Do you want increased cash flow? In multifamily investing, the right answer for these problems is always Raise your NOI. By raising your NOI, you can increase your DSCR, free up cash, and get more leverage. This is property management 101: raise the income and drive expenses down.
You can tweak your approach in your current multifamily investments to qualify for more multifamily deals. Here are five steps you can take now to qualify yourself for the loan program you want:
- Choose a property manager that has similar ideas and methods to you—and is willing to put cost-saving policies in place without skimping on quality management and upkeep.
- Be proactive. Examine your expenses regularly and communicate your interest in cutting costs wherever possible to your property manager. Some owners never do, and so there’s no active campaign to look for ways to improve.
- Shop the cost of services annually to keep your service providers motivated to keep you as a client. Of course, balance that with the quality of the service and how it’s delivered. Don’t forget that there’s a balance between cutting costs and cutting quality.
- Raise rents. However, remember that having an empty unit will hit your collections numbers, which is also detrimental to your NOI. Check your rents to ensure they’re in line with the local market, and benchmark your best competitors to stay up with current trends.
- Increase “other income” by implementing a ratio utility billing system (RUBS) program, implementing a mandatory media package, or charging for parking. You can get creative while still being smart and ethical. You can add value to your property in simple but effective ways.
Remember: the most effective way to navigate the myriad of commercial mortgage options for multifamily properties is to start thinking like a lender. The more you know about how loan terms and structures are calculated and underwriting guidelines are applied, the better equipped you’ll be to secure the ideal loan for your goals. Understanding your DSCR is just one of the first steps.