Monday, August 18, 2008

The Final Puzzle Piece: Debt Service Coverage Ratio

Over the past week or so, I have discussed some of the basic criteria and analysis that go into the determination of the viability of a commercial mortgage loan. We have looked at how we get to a building’s net operating income or NOI. This is key, because it tells us how much, after expenses, the building earns. And remember, in a commercial loan the key is what the building earns. This is one of the reasons why two side by side buildings with the same number of stores and apartments above can be worth two different amounts. Different levels of NOI! We have looked at capitalization rate, or the return that a buyer of a commercial property wants on their investment. We showed how this number, along with NOI, can give us an idea of what a building is worth.

Now let's put it all together, and look at what an underwriter is going to look at. Will this income be able to service the desired loan at the appropriate level.

Debt Service Coverage Ratio or DSCR

We are now going to examine the most important number, the number which will go a long way in determining whether or not a commercial mortgage loan can get funded. It is a number that can get a loan amount cut, or even potentially increased. This number is the debt service coverage ratio, or DSCR. Remember what we said early on. Commercial mortgage loans are not about LTV, but they are about the DSCR.

DSCR is not a complicated formula, but it will tell us if the debt service (principal + interest) of a given loan amount at a given interest rate will be adequately covered by the NOI that the building produces. Again? Will the annual NOI divided by the annual debt service coverage of the desired loan result in a DSCR high enough to satisfy the lender. Typically, the minimum DSCR level will be 1.20X or 1.25X depending on the property type.

Now let’s take a look at an example. Remember that the calculations are not complicated, but the results are critical to the success or failure of loan funding:

NOI = $80,000 Annual Mortgage Expense = $65,000

DSCR = $80,000/$65,000 = 1.23X which is OK for certain property types

What if the NOI goes down, or the mortgage expense goes up?

NOI = $75,000 Annual Mortgage Expense = $68,000

$75,000/$68,000 = 1.1X DSCR which is not a good number.

A way around this is a lower loan amount which will result in a lower mortgage expense. This will require a larger down payment for a purchase, or lower proceeds in the event of a refi.

If a DSCR is just below the required number (i.e. 1.17X when 1.20X is required), exceptions by an underwriter can be made. The decision to make the exception will be affected by the state of the market (not to many exceptions going on now), as well as the relationship that you have with the underwriter. If you have always brought quality deals and know what you are doing, your situation will be considered more seriously than someone who typically brings questionable deals and seems to not know what they are doing.

In any event, the bottom line still remains that:

The Income Producing Property Must Be Able To Support Itself!

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