Assessing Real Estate Investment Risk Using Debt Service Coverage Ratios
Real estate investors can reach into a lender’s toolkit to help them assess potential real estate investments. One tool, the Debt Service Coverage Ratio (DSCR), is a common metric lenders use to underwrite real estate loans. It is a measure of the projected cash flow available to pay debt obligations on the property's real estate loan. In this article, we will describe DSCRs and explore how they can be used in conjunction with other metrics, such as IRRs to provide more insight on risks relative to returns in comparable assets.
Real estate investors can reach into a lender’s toolkit to help them assess potential real estate investments. One tool, the Debt Service Coverage Ratio (DSCR), is a common metric lenders use to underwrite real estate loans. It is a measure of the projected cash flow available to pay the debt obligations on the proposed real estate loan and is calculated as follows:
DSCR = Net Operating Income (NOI) / Total Debt Service
Lenders use DSCRs to determine whether or not they will issue loan terms to borrowers and, assuming they do, they then use DSCRs to size loans. They also use DSCRs to assess risk and determine fees and interest rates they charge on loans. Since lenders use DSCRs to size up a deal, investors can also use this metric to compare and contrast different investment opportunities. In this article, we will describe DSCRs and explore how they can be used in conjunction with other metrics, such as IRRs to provide more insight on risks relative to returns in comparable assets.
If the annual net operating income of a property is $3 million and the annual debt service is $2 million, then the DSCR is 1.5. So what does that number mean? For starters, it means that the property can suffer a $1 million decline in NOI and still service its debt. It also means that beyond a $1 million decline in NOI, the property drops below a 1.0 DSCR, which is an important number. A DSCR below 1.0 is bad as it means a property no longer has enough net operating income to service its debt. Furthermore, if a property drops below a 1.0 DSCR for a prolonged period of time without an immediate path to get back above that threshold, then the probability of the borrower defaulting on the loan increases substantially. Therefore, the closer you get to a 1.0 DSCR, the more lenders become nervous as unexpected hits to revenues (such as a vacancy or a tenant default) or increases to operating expenses could cause a default.
While there is no absolute standard when it comes to preferred or accepted DSCRs, there are general underwriting guidelines for institutional-quality assets that vary across asset classes. For example, for multifamily assets, agencies such as Fannie Mae or Freddie Mac seek minimum DSCRs of 1.2 or 1.25 (depending upon the asset and amount of leverage sought) when underwriting loans. Given the relative stability of multifamily assets in comparison to other asset classes, lower DSCRs are justifiable. In comparison, if you were underwriting a similar quality stabilized office or retail asset in a similar market, the greater level of tenant risk (e.g. fewer tenants each of whom accounts for a greater percentage of operating revenue) would mandate a higher DSCR, such as 1.5 or greater. Generally speaking, DSCRs can range from below 1.0 (in the case of a heavy value-add deal where you plan to lease up a building with an interest reserve to service the first two years of debt) to upwards of 3.0. While it’s possible to have a DSCR above 3.0, particularly if the amount of leverage placed on a property is low, it’s rare. For most commercial assets, a DSCR above 2.0 is attractive as it means the property has a good margin of error for unforeseen occurrences that could negatively affect NOI yet still provide enough cashflow to service its debt.
Using the DSCR to understand risk vs. reward
Investors can use DSCRs to better understand the risk in a real estate deal. For example, an investor can use the ratios to compare two apartment investment opportunities in Dallas that, from the outset, appear to have similar profiles in terms of unit counts, asset class and location.
Property A has a DSCR of 1.6 and a targeted IRR of 14%. A relatively high DSCR for a multifamily property means it is more stable and it could withstand sudden changes, such as a 5% drop in occupancy without risk of default. It also means you can expect greater dependable cash flow. By comparing the DSCR to the targeted IRR, we can categorize this asset as Core-plus.
Property B has a DSCR of 1.2 and a targeted IRR of 18%. Based upon the guidelines above, you almost know that the sponsor has, at least initially, maximized the amount of available debt. As you learn more, you discover that the sponsor has opted to be more aggressive on debt at acquisition because of a unit improvement plan that will translate into higher rents at lease renewal. Therefore, while the year 1 DSCR is 1.2, the pro forma suggests a DSCR of 1.7 by year 3, which makes sense if the unit improvement plan is implemented. By comparing the initial vs. future DSCR to the targeted IRR, we can now categorize this asset as Value-added.
Debt vs. equity underwriting
Investors sometimes have a tendency to believe that, if a lender is involved in a transaction, then it has been through a rigorous due diligence process that also benefits them. While it is true that lenders conduct substantial due diligence to get comfortable prior to committing to lend on a property (which includes items such as title and survey review, environmental reports and physical inspections), it shouldn’t necessarily correlate to equity investors feeling equally comfortable. Investors should keep in mind that the lender has conducted due diligence sufficient to feel comfortable with its downside exposure in the transaction, which might come at the expense of equity investors. The lender may also be willing to take on a bigger loan risk if it is charging a higher fee on the loan. Or, the lender may be willing to assume more risk due to competitive pressure to win the deal. Having a lender in a transaction is good from a checks and balances perspective, but it doesn’t mean that investors can outsource their own due diligence.
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