The debt service coverage ratio is another way for the bank to determine how you are doing as an owner. We’ve talked about it before as a way to help the bank analyze the purchase, but it doesn’t end there. The bank may also look at the DSCR when you are financing another property.
DSCR as a Borrowing Tool
DSCR is often coveted by new investors, looking for a way to get into a property with either low money down or with poor credit. It offers a way for the bank to evaluate the deal on its own and the investor hopes the bank will put more weight on the deal itself than the investor. In practice, it’s difficult to get this type of loan without a track record. The investor has so much impact on how the deal goes, such that a bank is not going to want to risk so much with a DSCR loan. In other words, the deal can be amazingly good, but with a bad operator, the deal is immediately bad. DSCR is going to be for those with more experience but not so much capital because of prior investments.
Conventional Debt
The DSCR is used by banks as another metric to evaluate your deal. It is the ratio of net operating income the debt service (what you pay in principal and interest). Banks have their own cutoff, but expect this to be around 1.3. It can go lower depending on experience and financial strength of the operator. On these conventional loans, you are not often asked to provide the DSCR on previous properties, but as the loan amount gets bigger, this question might be asked.
Agency Debt
Agency debt is what you think of as Fannie Mae and Freddie Mac. In larger multifamily properties, these agencies are highly sought-after for loan money. They usually will give a long amortization and a lower interest rate than you can get at a typical bank. The downside is in the large amount of red tape.
Generally for agency debt you will work with a broker who acts as an intermediary. That broker will work with you to collect the necessary paperwork. The agency will want a huge amount of documents verifying who you are and your ability to pay back the loan. If it’s your first time using this type of debt, the bar will be even higher.
The bank will want a Schedule of Real Estate Owned (SREO) and in it the borrower will compute a DSCR for every project they own. If any of these are below their cutoff, the borrower will have to explain the reason it is low. The bank uses this as another tool to help them determine the creditworthiness of their potential borrowers.
As you grow your business, you will need to get familiar with the DSCR and you will also need to follow what your projects are doing in terms of DSCR. This way you can be ready for the next time you want to start a big project.
