One of the most important concepts in realestate investing is leverage. Leverage is the ability for someone (or a team ofpeople, such as a sponsor or development group) to finance a substantial partof the property's acquisition and/or redevelopment costs. Unlike stocks, bondsand other equity investments that require someone to pay face value, investors can use leverage to limit theirup-front and out-of-pocket expenses. For example, if someone is purchasinga $1 million property, they might be able to finance $750,000 using atraditional bank loan. This leverage limits their out-of-pocket expenses to$250,000 - a much lower barrier to overcome than having to pay $1 millionpersonally.
However, obtaining a loan of this size (ormore) can be difficult. Lenders will usually look at both the borrower'spersonal income and value of their assets, as well as the property's income-generating potential.
When evaluating whether or not to make a loan,lenders will use a metric known as the "debt service coverage ratio" to assessthe latter—i.e., the property's income-generating potential. In this article,we look at the importance of DSCR and how investors can use this metric tomitigate their risk.
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What is the Debt Service CoverageRatio (DSCR)?
The debt service coverage ratio, oftenreferred to as "DSCR," is a metric that bothinvestors and lenders use to determine whether the income generated by aproperty can sufficiently support its debt obligations.
A property with a DSCR of less than 1.0 isconsidered to be losing money and would not have enough income to cover debt payments. A property with a DSCR greater than 1.0 is considered to beprofitable. From a lender's perspective, the higher the DSCR, the better.
The DSCR ratio is used in conjunction with theloan-to-value (LTV) calculation. Propertieswith a higher LTV ratio may have a lower DSCR ratio and vice versa.Therefore, in order to meet a lender's preferred DSCR ratio, a borrower mayneed to put more equity into the deal to lower the LTV. Ultimately, this is oneof the primary ways lenders mitigate the risk of borrower default.
Related:Terms andDefinitions: Debt Terms
How to Calculate the Debt ServiceCoverage Ratio
The debt service coverage ratio is as follows:
- DSCR = Net Operating Income (NOI) /Debt Obligations
In order for this calculation to be accurate,the borrower needs to have a strong grasp on the property's NOI.
The NOIincludes all rental income plus other income (e.g.,parking fees, storage fees, laundry or vending machine income,billboard/signage fees, etc.). Vacancy losses and all operating expenses(including property taxes, maintenance, and management fees) are thensubtracted from that sum to determine the NOI.
- NOI = Total Income - Total OperatingExpenses and Vacancy Losses
Debt obligations are more straightforward. Ata minimum, it is the principal and interest payment owed to the lender eachmonth. A lender's DSCR calculation might include property taxes and insurance,as well. If these are included as debt obligations, they should not be factoredinto the operating expenses when calculating total NOI. They should only beaccounted for once, on either side of the DSCR equation.
By way of example, let's say a self-storage facility has an NOI of $3.0million and annual debt obligations of $2.2 million. In this case, the DSCRwould be:
- $3.0million / $2.2 million = 1.36x DSCR
Most lenders like to see a DSCR of somewherebetween 1.25x and 1.50x, so the example above would represent a relativelyhealthy DSCR. From a lender'sperspective, the higher the DSCR, the better, as this means there is moreincome available to cover debt obligations.
Related:Terms andDefinitions: Income and Expenses
The Importance of DSCR
DSCR is important to any borrower interestedin securing a loan to purchase, renovate or refinance a commercial property.This is true regardless of product type (i.e., multifamily, office,hospitality, retail, self-storage and the like). Some lenders may be willing to make a loan based solely on a borrower'sincome, credit and the value of their assets. Most, however, will also lookat the amount of income that will be generated by the property and whether thisis sufficient to cover debt obligations.
This is particularly true among asset-basedlenders, who almost exclusively rely on DSCR to determine whether a borrowerqualifies for a certain loan amount. The more income a property generatesrelative to its debt service obligations, the greater the likelihood of loanrepayment. Most lenders want to seeDSCRs of at least 1.25 to 1.50x. This means that the property generates1.25 to 1.50x the income needed to make debt payments.
With a particularly strong DSCR, a borrowermay be able to secure a loan at favorable terms regardless of their personalincome or credit history.
Aside from financing implications, DSCR can bea useful tool for those looking to conduct a quick, side-by-side analysis ofvarious investment opportunities. While DSCR is onlyone metric to consider, it provides a quick, easy-to-understand snapshot of aproject's potential profitability.
Using DSCR to IncreaseProfitability
DSCR can prove to be very insightful forinvestors. An investor might, for example, look at the in-place NOI and debt obligationsand then, assuming the DSCR is low, may use this as an opportunity to identifycost savings. For example, an investor may find that in-place rents arebelow-market average. If they are ableto increase rents by 10 percent, that may increase the DSCR calculation.
Likewise, an owner may find that theiroperating expenses are higher than average. This could be the incentive anowner needs to revisit vendor contracts or make property improvements that willlead to greater efficiencies.
As you might imagine, a property's DSCR can fluctuate over time. Thecalculation relies on a snapshot in time; the inputs to that calculation maychange from year to year as leases renew, tenants roll over, propertyimprovements are made, etc. Assuming a property's DSCR substantially improveswith time, it may be worth refinancingthe existing loan into a new loan at a lower rate or better terms sincelenders will find the deal more attractive as the DSCR increases.
Collectively, any adjustments an owner makesto improve the DSCR will result in greater profitability for investors, aswell.
Related:How SelfStorage Is Managing These Turbulent Times
Conclusion
The DSCR is an important metric for anybusiness owner interested in obtaining a loan - real estate related orotherwise. The higher the going-in DSCRand the higher the projected DSCR after property improvements, the lessrisk associated with debt repayment. Deals that have less risk will inherentlyqualify for better rates and terms among commercial lenders.
By understanding a property's DSCR, investorscan make more informed decisions about property improvements, operations, andfinancing alternatives - decisions that will ultimately impact a project'stotal cash flow, and by extension, the returns investors might expect.
If you would like to get started with investing inself-storage, reach out to us and we will help you getstarted.
