One Real Estate Metric You Need To Know
The debt service coverage ratio (DSCR) can make or break your project. Here's how.
Hey — Jonah here. Welcome to the next edition of Brick + Mortar where readers get insight into the acquisition, financing, design, construction, and operations of small-scale real estate development projects.
First, an update on 501 Main. Then, a look at how debt service coverage ratios work.
501 Main update
We have two more weeks with the boom lift.
Making hay while we can.
In between snow storms this past week, we were able to install siding boards and trim on the north side. Next, we’ll finish up that side with battens, metal wainscot, and painted panels on the parapet.
Debt service coverage ratio: a cautionary tale
If you don’t know what a debt service coverage ratio (DSCR) is, you should.
Especially if you’re looking to build or purchase real estate.
It’s the holy grail of lender metrics.
DSCR = Net Operating Income / Annual Debt Payment
Note: Net operating income (NOI) is income after operating expenses are paid.
Put simply, DSCR is an indicator of whether an asset can afford its debt service.
If DSCR > 1, you’re in the clear. But if < 1, you won’t have enough income to make mortgage payments and you risk foreclosure.
Let’s use 501 Main as an example:
NOI = $75,000 / yr
Principle + interest payments = $60,000 / yr
DSCR = $75,000 / $60,000 = 1.25
This is good.
This means I have enough income to cover debt payments and have a little left over to pay a return on capital invested.
Generally speaking, lenders want to see a project underwrite at a DSCR of 1.25 or above. A little buffer reduces risk all around.
Ok.
You get the basics.
Let’s take it up a notch.
To be precise, the debt on 501 Main is structured in two phases:
During construction, the debt is variable and interest-only. Each month, my interest payment fluctuates based on the market
Once construction is complete, the loan is converted into a 20-year amortizing note at a fixed rate for 10 years. That rate is not locked until construction is complete
Did you catch the nuance there?
My permanent financing doesn’t actually rate lock until we wrap up construction.
The example above was my projection based on rates at the time (during the planning phase).
But, what started off in January 2022 at 4.25% when we closed the construction loan is now up to 7%.
And lenders anticipate that to continue climbing into next year.
We anticipate being move-in ready by February 2023 which means we could be facing interest rates of 8-9% by the time we’re able to lock a rate.
This is a massive risk.
What I initially projected as $60,000 per year in debt payments could easily turn into $75,000 or more.
And, with $75,000 in NOI per year, the implications are glaring:
Little to no cash flow to pay returns on investment capital or cover unanticipated expenses
Inability to make debt payments without influx of additional investment capital should debt payments exceed NOI (i.e DSCR slips below 1)
As one of the carpenters on my team says when he doesn’t like the way something looks—this is total caca.
The worst part is this isn’t really a scenario that I could have realistically accounted for during initial underwriting.
Sure, I looked at a bit of interest rate expansion from 4% to 5.5% and the deal still penciled.
But who could have foreseen a black swan event where interest rates more than double in the span of 12 months?
This isn’t a pity party though.
For one, nothing ever goes according to plan. If you want to develop real estate, you need to be comfortable adapting and pivoting on the fly. I’ve found that’s mostly learned the hard way.
And two, there’s always a path forward. You just have to keep poking until you find it.
For 501 Main, this could mean a few things:
Infusing more equity capital into the project to pay down the loan early (and therefore reduce debt payments)
Restructuring the debt to lock in a rate earlier and/or extend the amortization period (also would reduce debt payments)
It’s early though.
I still have more digging to do.
But if you’re considering a development project, I would just take this as a cautionary tale.
Understand that anything can happen.
And Murphy’s Law loves to flex when you least expect it.
For the developers reading this—how have you dealt with this kind of situation?
Until next time.
— Jonah 🧱
P.S. Want to connect? Find me on LinkedIn and my projects on Instagram.
Recommendations:
1. See if the DSCR pencils with a 30 year amortization with at 10 year lock (most lenders won't go longer than 10 year lock on the interest rate, but some do and if so, explore those options). That may be enough. If not
2. Infuse equity capital: This can be done using the additional equity capital to pay points (interest up front) to buy down the rate.
3. Once the above are in place, breathe a sigh of relief, manage your development superbly, and if an when interest rate environment is better, refinance taking into consideration any prepayment penalties on the mortgage loan (preferably negotiate a loan without any such penalties).
4. Hold long term.
Best wishes.
Mark Preston
As my late father said
“These deals are not easy to put together.”
As a consequence, he was a long term investor. He rarely sold, only doing so if absolutely necessary.