Debt Service Coverage Ratio (DSCR): 101
Get ready for a lively and vigorous discussion about a very important and relevant topic . . . one that you may be hearing about for the first time if you've only been buying real estate for the past 5 years. Yep, you guessed it -- Debt Service Coverage Ratio! (DSCR)
I wanted to discuss this topic on our blog because for the first time in my career, it's an extremely relevant metric. Thankfully, my mentors always made me calculate the DSCR even when it wasn't relevant. DSCR is a metric that your lender will use to constrain your leverage. It's a measurement of your cash flow in relation to your debt, so a bank can ensure that the property is producing enough income to pay them back (and a little extra, just in case).
DSCR is a simple calculation:
Net Operating Income (NOI)/Annual Debt Service
Example: If your property is spitting out gross rents of $100k/year and running at a 25% expense ratio then your NOI is $75k. Let's assume you have $700k in debt at 6% 30 yr am, then your monthly payment is $4,197 -- putting your annual debt service at $50,364. To calculate DSCR, we'll simply divide $75k by $50,364. In this case that gives us a DSCR of 1.49
What does this mean? This means that the property produces net cash equal to 149% of the debt payment. This would be considered a safe loan, because there's a lot that would have to go wrong for the bank to be in danger of not receiving their payment.
**Important to note** Most banks require a DSCR of 1.2-1.25
Now, why is this becoming relevant for the first time in 5 years? Because debt has been so cheap! Banks will usually constrain your leverage to 70-80% of value (most often 75%) with a commercial loan. Since debt has been so cheap we've all been taking max leverage on every deal. And even at 75% leverage we have a DSCR of 1.3 or 1.4 or 2.0!! Cheap debt allows your free cash flow to flourish. HOWEVER, expensive debt is a totally different story . . . .
Debt figures have basically doubled. To put this in perspective, we used to get 30 yr fixed commercial debt at 4.5%, now that same product is sitting around 8% -- let's see what that does to our debt payment. Using those figures, the annual debt on a $500k loan goes from $2,533 to $3,669. *Yikes*
This means that for the first time ever in my career -- we're not constrained by LTV, but by DSCR! If our loan allows us to take out 75% LTV, but requires a 1.25 DSCR, we end up hitting that 1.25 DSCR before we reach 75% leverage. We may have to take 70 or 65 or even 60% leverage! This is a game changer when looking at various return metrics -- especially cash on cash return. More cash left in the deal, means lower % return on that cash, even if the return is a bigger overall number.
The market is shifting quickly and yesterday's rules are not today's rules. We also have to prepare for tomorrow's rules to be different from today. This makes development deals much more risky because of the timeline. The longer the timeline on the deal, the more conservative your underwriting better be. And this is only focusing on one variable. Stay vigilant out there people!