By Victor Alarsa
If you are looking to get into Real Estate financier, here you will find a few metrics commonly used by loan underwriters.
As discussed in part 01, covenants are financial metrics used by lenders to determine how risky lending capital might be for a given project. We learnt about LTV/LTGDV/LTC, and now we are going to find out a bit more about two other important ratios: DSCR and ICR.
DSCR (Debt Service Coverage Ratio)
In short, DSCR is the ratio between cash available and cash required for debt servicing. In other words, it is the ratio of the right amount of cash to repay the debt.
Commercial lenders use the DSCR to assess how large a commercial loan can be supported by the cash flow generated by the asset.
One of the reasons why a commercial loan is denied is because the property does not meet the financier’s minimum DSCR requirements. Understanding how a commercial lender calculates the DSCR is essential for appraising leverage cash flows consistently.
The ratio states net operating income (NOI) as a multiple of debt due within a given period of time, including interest and principal payments. The period of time may vary, could be a looking forward or backwards basis – month(s), quarter(s) or year(s). Being one of the common terminology LTM, standing for the last twelve months.
We will understand the formula and its calculation below.
The formula for Debt-Service Coverage Ratio (DSCR) is:
DSCR = Net Operating Income / Total Debt Serviced (interest rate serviced + amortization)
Example 01, if a property has an annual NOI of £125,000 and annual mortgage debt serviced of £100,000, the DSCR is 1.25x.
Example 02, if an asset has the same NOI and interest serviced of £90,000 and principal repayment of £25,000, the DSCR is 1.15x.
A common mistake made by borrowers when applying for a commercial loan is that the bank or commercial lender only uses the actual expenses from the property when calculating the NOI. However, commercial lenders use a combination of actual expenses and common market expenses assumptions.
Therefore, if the property is operating more efficiently than common market comparables (due to efficient self-management), the lender underwriter might take the worse case between actuals and market assumption for calculating the NOI, reducing the NOI, reducing the DSCR.
The general starting point on the commercial loan is around 1.2-1.25x of DSCR. However, this number varies depending on who the lender is and the property type.
Typically, DSCR requirements are higher on riskier property types, such as hotels, since their income varies based on competition and seasonal factors. Many lenders prefer hotels to have a DSCR of 1.4. In comparison, DSCR requirements are often relaxed for properties in which tenants have long-term leases.
Some lenders may provide commercial real estate loans based only on DSCR, others may ask for ICR or both.
Interest Coverage Ratio (ICR) is very similar to DSCR; the only difference is that it does not consider amortisation of the main facility, only capitalised interest rate. Let’s see its formula.
The formula for Interest-Cover-Ratio (ICR) is:
ICR = Net Operating Income / Total Interest Rate Serviced
For example, if a property has an annual NOI of £125,000 and annual interest rate serviced of £100,000, the ICR is 1.25x.
Together with part 01 (LTV/LTGDV/LTC), ICR and DSCR are the most common financial metrics to assess and prepare the head of terms (HoT) for a borrower.
In the next article, we are going to learn more about specific terminologies, such as commitment fee, instalments, drawdowns, maturity, and others.
If you would like to learn more, you may be interested in our Real Estate Investment and Financial Modelling course.
The Real Estate Investment and Financial Modelling course is a great opportunity for anyone seeking to develop their modelling skills. The contents of the course will be useful for entry-level graduates, APC candidates and experienced professionals alike.
Also, feel free to take a look at our full list of upcoming courses and choose a date to take your financial skills to the next level!
We hope you have enjoyed this article and we are looking forward to seeing you again for part 03, coming next month…