What are the common pitfalls and risks of underwriting a commercial loan based on the DSCR?

Especially in development, the NOI of a property is unknown. DSCR is just one metric used to size a loan. Before leasing, a developer can have more comfort using loan-to-cost (LTC), especially when there's a gross maximum price (GMP) construction contract. A thorough model will use the minimum of LTC and DSCR to find the assumed debt load the project can bear. This more conservative approach protects a project from downside risk if leasing markets deteriorate before construction completion. The replacement cost of the collateral provides a floor on the value a lender will assign it, which the DSCR approach doesn't offer.

When a loan has an “interest only” period, the ADS payments during that time will be lower than when there is amortization. As such there is a debate between lenders if they use the interest only period to decide the minimum DSCR ratio or do they use the DSCR assuming there is amortization

Prudence dictates employment of an amortizing loan to estimate the DSCR. In addition, even if reserves are not collected, it makes sense to use net cash flow rather than net operating income in the DSCR calculation.

Additionally, in order to make sure you keep your underwriting (and yourself) honest defaulting to a minimum DSCR that is "fully loaded"...meaning calculated on both principal and interest payments from day one of the hold, even if your loan has an initial interest only period.

In my experience DSCR is useful in properties where the actual and proforma NOI can be easily ascertained (ie/ a multi-family property located in a healthy market with numerous rental comparables to draw from). It gets more complex when dealing with assets that do not have adequate market data to draw from (ie/ a 75,000 sq ft industrial building purpose-built for a fiberglass manufacturer. The tenant might be paying a rate that hits the requisite DSCR threshold, but what happens if they default or leave at the end of their lease? Conversely, what if the building is in a hot area and the lease rate they are paying is dramatically below market?

Nothing is really flawless. The hedge that lenders use is the raising and lowering the the required DSCR to offset the risk. On a stable long term multi family deal they might be fine with a 1.2x DSCR but for a riskier deal they might want 1.3x or higher.

One of the biggest disadvantages of DSCR is taking in consideration only the main source of cash flow: I.e. base rent and disregarding the costs draining the cash stream.

The DSCR is just one indicator used to evaluate risk. However, it can change drastically and quickly. For example, in retail if a single tenant property has a DSCR of 1.2 in January and the one tenant closes shop unexpectedly in February that healthy DSCR the month prior is worthless. It is a good indicator for certain asset classes and scenarios but to properly evaluate risk a more comprehensive view of the property is needed.

I agree ?? and that is why over the last 10 years this metric has become more valuable when deciding the final loan amount than anything else. And now with interest rates rising, this is causing the market to slow down faster since the cash flow is getting eaten up.

DSCR ignoring future rents, holdover and month-to- month revenue streams considered non- stabilized . From an evaluation stand point, DSCR is simple but not as complex and comprehensive as other tools.

A problem with the DSC valuation is that it ignores future rent rate reductions on upcoming lease renewals or new leases as could be coming, especially on commercial properties.

As we prepare to move into a possible slowdown, there will be lots of distressed opportunities. Many investors are looking to "buy the dip" and have been on the sidelines waiting for this moment. However, many forget that there's usually a credit crunch that comes with a recession. Anticipate a pullback in CRE loan sizes and access to credit. DSCR becomes the most critical factor. Backing into a loan size with a healthy, fully-loaded DSCR, above 1.2x will help increase chances of a loan approval during these turbulent times.

Realize that the key to this working out is only if you underwrite the deal properly and this way the NOI truly becomes the trusted number to reach the DSCR as well as the cap rate to hit the value.