In the search for an investment property, one of the first things any investor will consider is the property’s ability to cover its own operation and debt costs. Your lender will be just as, if not more, interested, and their underwriting team will delve deeply into the property’s recent financials calculating the annualized Debt Service Coverage Ratio (“DSCR”) to project the property’s long-term financial performance.
At its most basic level, the DSCR’s calculation formula is DSCR=Net Operating Income/Debt Service. However, each lender may have additional factors they include in their calculation based on whether the loan has a fixed or floating interest rate; an interest rate cap agreement; or other unique components. It’s best to speak with your lender or originator directly about how DSCR will be calculated for the exact loan you’re seeking.
Once you’ve obtained the loan, the calculation for the DSCR will usually be spelled out in the loan agreement. Having the correct formula will allow you to understand what your lender prioritizes, and to check in on the property’s performance yourself throughout the life of the loan.
The loan agreement will also provide for a minimum DSCR that must be met by the property to avoid getting in hot water with your servicer. A DSCR below 1:1 means that the property’s debt obligations exceed operating income, and the property will unlikely be able to cover its mortgage payment and other expenses.
When DSCR is calculated as 1:1 your net operating income just covers the property’s debt service obligations with nothing to spare. This property is likely not a strong investment and fails to provide a cushion of additional funds for unexpected expenses. Basically, you’re breaking even. In most loan agreements I’ve seen in the last 4 or 5 months, the DSCR requirement has circled around 1.25:1 with some rising as high as 1.35:1.
Not meeting your minimum DSCR often leads to higher scrutiny from your servicer, and getting to know the asset manager assigned to your property very well. As they will be contacting you for updated financials and rent rolls. If your DSCR falls below 1.10:1, lenders like Fannie Mae and Freddie Mac, will automatically put you on a “watchlist”. Your servicer will be obligated to send information periodically to the lender to assure them that steps are being taken to address the property’s financial distress, including a summary of your “action plan” to bring the property’s performance back to underwriting’s projections and identify the reasons for the struggling financial performance.
The servicer may also send an inspector to verify the condition of the property to certify that there isn’t an issue at the property leading to lower rent collection or higher repair/maintenance costs. Your servicer will also be completing regular Google searches on the key principals and the property to ensure there hasn’t been any negative press or lawsuits draining property funds. Additionally, you may be required to deposit funds into an escrow account to make mortgage payments in the event of a payment default on the loan.
Your property’s declining DSCR and the interactions with your lender can be very daunting. However, knowing your property’s ability to cover its debts is a great tool for assessing the long-term financial health and to strategize and improve your investment. If you’re facing issues with your lender based on a low DSCR, or would like to discuss your options before sending financials please feel free to reach out to me at smacpherson@patellegal.comor (972) 435-4339.