Most commercial mortgage loans include a clause that requires the property to maintain a minimum DSCR (Debt Service Coverage Ratio). Experienced property owners will do that math quickly in their head: DSCR = Net Operating Income / Debt Service (full loan payment that may be interest-only or amortizing, which means paying down principal).

Of course, the obvious use of this ratio is monitoring the risk of potential default. A low DSCR (close to 1.0x) means the property’s net income is barely sufficient to cover loan payments.

But it’s important to note that DSCR isn’t purely a performance monitoring metric. It’s a measure that will affect the underwriting of your loan, and can determine how well a sponsor (borrower) is able to finance their asset. Here we’ll explain the DSCR’s role in loan underwriting, and the affect it has on loan terms in this historically-low cap rate environment.

DSCR’s relationship with Cap Rate

When acquiring a property, a low cap rate and a high DSCR requirement can shrink your loan proceeds. I think this is best shown in examples. Loan quotes shown here are for illustrative purposes only.

Example

You’re buying a stabilized multifamily asset in New York, where such properties trade at very low cap rates.

If Purchase Price $10,000,000 and NOI = $425,000 then Cap Rate = 4.25

You’re able to net two competitive loan quotes for the deal, and you’re most concerned about maximizing leverage. At first thought, you’re excited about an agency loan from Fannie Mae or Freddie Mac, because you know they can go up to 80% LTV while staying non-recourse.

But in New York, that’s not the case.

In order to cover a 1.2x DSCR with the agency lender, the max proceeds they can reach would be around $5.6 Million, an LTV of 56%, a far cry from the max 80% you hear about. Given the $425k NOI, the property would need to trade at a much higher cap rate to reach 80% leverage.

The balance sheet lender here, Goliath National Bank, would be higher leverage (up to ~63.5% LTV), purely based on their lower standard for debt service coverage.

Maximizing returns while managing DSCR risk

There are a few strategies for managing your DSCR risk.

Buy value-add — if you can “increase the cap rate” on a property you own, and then refinance, the equity you’ve built up on the property should help you reach higher loan proceeds.

Buy at higher cap rates — this may mean hunting for properties in markets that are more advantageous for buyers. Higher risk, higher reward, higher cap rates.

Use lower leverage— more equity is required, but you’re building in a larger margin of safety from a default.

Find the right lender — in New York, to achieve higher leverage you need to use a bank or credit union that understands the local market, and tailors their lending programs appropriately. FYI, Goliath National Bank is fictitious, so don’t try calling them!

At StackSource, we try to make the analysis of trade-offs between financing options easy to navigate. Clients financing with us get access to our loan quote analysis tools which lets you visualize your cash flow, debt service coverage, and holistic returns based on available financing scenarios.

Screenshot of StackSource loan quote analysis tool

Our borrowers also benefit from access to an expert Capital Advisor on every deal, who will be ready to walk through the scenarios, make recommendations, and structure an ideal financing package that fits the investment goals.

If you have any questions or would like to see some loan options for your commercial property, chat with us live on StackSource.com or shoot an email to hello@StackSource.com.