Debt Service Coverage Ratio- What is it? Why is it important?
Let’s face it.
Buying real estate has been challenging.
The search for yield has driven real estate prices to all-time highs. This has led many investors to wonder just how high pricing can go.
While it’s true the cost of real estate has gone way up, it is important to remember that the cost of the debt (interest rate) used to purchase real estate had also gone way down (rates have since started rising).
Therefore, one of the metrics we look at when evaluating a property is the Debt Service Coverage ratio or DSCR.
What is the Debt Service Coverage Ratio?
The Debt Service Coverage Ratio (DSCR) is a calculation used by lenders to determine the ability of a property to generate enough cash flow to cover its debt obligations. The ratio is calculated by dividing the property’s net operating income by its total debt service. A DSCR of 1 or greater means that you will have enough income to service your debt (pay your loan).
A low DSCR can indicate that a property is not generating enough cash flow to cover its debt obligations, leading to a default on the loan. This could lead to foreclosure on the property and loss of principal for the investor.
A high DSCR indicates that the property is generating more than enough cash flow to cover its debt obligations, which reduces the risk of default for the lender.
When calculating the debt service coverage ratio, you’ll want to use the most recent 12 months of data. This will give you an accurate picture of how the property is currently performing.
How Can You Improve Your Debt Service Coverage Ratio?
1. Increase revenue
The common one here is increasing rents, but you can also increase revenue by:
· Billing back residents for water
· Collecting late fees
· Charging for storage space or premium parking
2. Reduce overall debt levels
Making a larger down payment on a property lowers your Loan to Value (LTV) and will, in turn, decrease your monthly debt service (all else being equal with the loan).
3. Secure more favorable loan terms
A few things to consider here are interest rate and amortization schedule. A loan with a 30-year amortization schedule will have a lower monthly debt service than a loan that is amortized over 20 years.
4. Reduce expenses
Look for ways to reduce expenses without compromising the quality of the property/resident experience.
Why is the DSCR important?
Risk.
A property with a DSCR of 1 can barely service its debt. A lousy month with collections, vacancy, or an unforeseen event ( see COVID) can cause the property to fail to make debt payments. When lenders underwrite a deal, they typically like to see a DSCR of at least 1.25. This allows a property to have some room to operate during downtimes.
One of the reasons we are excited about the deal we currently have under contract, Gish Flats, a 66 Unit A-Class Apartment Building in Lynchburg, VA, is that it has a year one DSCR over 1.7. We see this as highly favorable given the current market conditions. We are seeing a lot of deals getting done with floating rate bridge debt. The risk with this strategy is that if rates continue to rise, the debt service will increase, and you will see a decrease in your DSCR. We feel that by acquiring this property with long-term fixed-rate debt at a year one DSCR over 1.7, we will be able to withstand any unfavorable market conditions.
Conclusion
In conclusion, the debt service coverage ratio is an important metric to understand and keep an eye on when investing in real estate. It can help you determine whether a property is a good investment and whether the property will be able to cover its debt payments. In the current environment, we believe that one of the best ways to mitigate this risk is by getting long-term fixed-rate debt at moderate loan-to-values. Feel free to reach out with any questions or comments.