If you are interested in investing or lending in commercial real estate, you need to understand how to measure the risk and return of a property. One of the most common and useful metrics to do this is the debt coverage ratio (DCR). In this article, you will learn what the DCR is, how to calculate it, and how to use it to evaluate commercial real estate risk.
The DCR is a ratio that compares the net operating income (NOI) of a property to its annual debt service (ADS). The NOI is the income generated by the property after paying all operating expenses, such as taxes, insurance, utilities, and maintenance. The ADS is the total amount of principal and interest payments on the loan used to finance the property. The DCR tells you how much cash flow is available to cover the debt obligations, and how much cushion there is in case of vacancy or market downturn.
DCR, commonly DSCR is essentially a measure of risk. It shows how much your revenue covers your debt payments. A 1.5 DSCR means your income covers 150% of your debt payments. A low DSCR means very little can go wrong. If you dip below 1 DSCR, you are in the red, my friend. Conversely, a high DSCR means you can absorb more curveballs. If you're at a 2.0 and drop to a 1.5, it's not nearly as big a deal as a 1.5 dropping to 1.0, because you're still cash flowing.
Debt service coverage ratios in commercial real estate are projected into the future based on certain base case or worst case assumptions. Since these are only assumptions, it is important that the subject property or portfolio exhibits future projected coverage ratios well in excess of 1.25 or 1.5, even under worst case assumptions, in order to show that there is a cushion built into the capital structure of the deal.
The DSCR is used to assess a property's ability to generate enough income to cover its debt obligations. DSCR= Net Operating Income/ Total Debt Service -Lenders use DSCR to determine the likelihood that a borrower will be able to make timely loan payments. They typically seek out a DSCR of 1.25 or higher- this is not to say that 1.25 is the number you should be seeking out. -Like lenders, investors utilize the DSCR to assess the financial stability of the real estate investment. It's important to have plenty of cushion here (1.25+) to ensure you can pay your debt in the event of that market rents decrease significantly.
The DCR is calculated by dividing the NOI by the ADS. For example, if a property has an NOI of $100,000 and an ADS of $80,000, the DCR is 1.25. This means that the property generates 25% more income than needed to pay the debt service. A higher DCR indicates a lower risk of default and a higher potential return for the investor or lender.
There is no definitive answer to what is a good DCR, as different investors and lenders may have different risk appetites and expectations. However, a general rule of thumb is that a DCR of at least 1.2 is considered acceptable for most commercial real estate loans. This means that the property has a 20% buffer to absorb any unexpected expenses or revenue losses. A DCR below 1 means that the property is not generating enough income to cover the debt service, and may face financial distress or foreclosure.
The DCR can help you evaluate the risk and return of a commercial real estate property in several ways. First, you can use the DCR to compare different properties and see which one offers a better cash flow relative to the debt service. Second, you can use the DCR to assess the impact of changes in NOI or ADS on the property's performance. For example, you can see how much the NOI would have to drop or the ADS would have to increase to make the DCR fall below 1. Third, you can use the DCR to negotiate the terms of the loan with the lender. For example, you can ask for a lower interest rate or a longer amortization period to improve the DCR and reduce the risk of default.
DCR Tales- PropertyA Vs PropertyB Property A boasts a robust NOI of $200,000, an ADS of $150,000, and an impressive DCR at 1.33. In the other corner, Property B presents a steady performance with an NOI of $180,000, ADS of $150,000, and a reliable DCR of 1.2. Lenders face a dilemma; Property A promises cash flow abundance, while B ensures stability. The Debt Coverage Ratio (DCR) becomes their compass, navigating through risk and reward. In this saga, NOI and ADS shape the narrative, negotiating terms to enhance DCR and mitigate default risks. DCR emerges as the storyteller, guiding lenders in the commercial real estate landscape. Armed with DCR wisdom, lenders seek harmony between the promise of cash flow and the assurance of stability.
If you want to improve the DCR of a property, you have two main options: increase the NOI or decrease the ADS. To increase the NOI, you can implement strategies to boost the occupancy rate, raise the rents, reduce the operating expenses, or add value to the property through renovations or upgrades. To decrease the ADS, you can refinance the loan with a lower interest rate, extend the loan term, or make a larger down payment. However, you should also consider the trade-offs and costs of these options, such as the impact on your cash flow, equity, and return on investment.
To improve the DSCR we need to work on improving the core operational income and reduce vacancy and both escalatable and non- escalatable costs. Other ancillary income like parking, termination fees, interest income are not considered as income by some of the lenders in the defination of income so it is of paramount importance to work on improving the core real estate income. We should also look at amenity programs like SHIFT, fitness center for improving revenue and work on reducing the operational expenses and accurate CAM recoveries to improve NOI.
To increase the debt service coverage ratio, it may sound simple: increase revenue, decrease expense. Easier said than done. Pushing rent may decrease occupancy resulting in lower income. Charging for amenities like parking may increase income, but result in more tenant turnover. Key is to identify sustainable revenue streams that can be optimized. Same for expenses. Reducing cleaning services may lower operating costs, yet lead to bad reviews and frequent turnover. Or passing on utility expense may seem like a hidden fee to a tenant. The single largest expense is going to be sent service, so a cohesive plan around financing might be the single most important item to increase the DSCR.
The DCR is a useful metric to measure the risk and return of a commercial real estate property, but it is not the only one. You should also look at other indicators, such as the capitalization rate, the cash on cash return, the internal rate of return, and the debt yield. Moreover, you should consider the qualitative factors that affect the property's value, such as the location, the market conditions, the tenant quality, and the growth potential. The DCR is a tool, not a goal, and it should be used in conjunction with other tools and analysis to make informed and profitable decisions.