Debt Service Coverage Ratio (DSCR) in Relation to CMBS Loans
In addition to LTV and debt yield, DSCR, or debt service coverage ratio, is one of the most important metrics used by lenders to determine if a borrower is eligible for a CMBS loan. The debt service coverage ratio can be determined by taking a property’s NOI (net operating income) and dividing it by its annual debt service. Most CMBS lenders require a property DSCR of at least 1.25x in order to be eligible for a loan.
To clarify, NOI is defined by taking all rental income and ancillary income and subtracting all operating expenses, including property management, repairs and maintenance (R&M), and replacement reservices, as well as state and county property taxes. Debt service includes all principal and interest payments a borrower is required to make.
For reference, a DSCR of 1.0x means that a property is breaking even, while a DSCR of below 1.0x means that a property is losing money, and thus the borrower cannot afford to pay their monthly debt service with their monthly net operating income.
DSCR Example and Calculation
Let’s say that a property is generating an NOI of $2 million, and has an annual debt service of $1.8 million.
$2 milllion/$1.8 million = 1.11x DSCR
With a 1.11x DSCR, this property would not be considered eligible for most commercial real estate loans, including CMBS and conduit loans. In order to boost the property’s DSCR, the NOI would need to be increased by either raising rents, increasing occupancy, or reducing operating expenses (OpEx), such as management and maintenance costs.
Alternatively, the DSCR could be increased by reducing the property’s debt service, which could be addressed by reducing the leverage of the loan, extending the loan’s amortization, or reducing the loan’s interest rate.
CMBS Loan DSCR Requirements by Property Type
As we mentioned earlier, most CMBS lenders require a property to have a DSCR of at least 1.25x to qualify for a loan. In some situations, lenders may permit a DSCR of as low as 1.20x if there are compensating factors, such as if the property is extremely high quality, has experienced ownership and management, and if the leverage is decent low.
In general, lenders permit lower DSCRs based on the factors mentioned above, with higher quality properties (think Class A assets in major MSAs) with experienced or repeat borrowers.
However, perhaps more importantly, DSCR requirements are dependent on the property type. CMBS DSCR requirements by property type generally include:
Apartment/Multifamily: 1.25-1.35x
Industrial: 1.25-1.35x
Retail: 1.35-1.40x
Senior Living/Assisted Living: 1.40-1.50x
Hotel/Hospitality: 1.35-1.45x
As one can see, property types deemed risker generally have higher DSCR requirements.
DSCR Considerations and CMBS Lease Requirements
Properties that have few, long-term leases, such as industrial or retail properties, require special attention from lenders, particularly in regards to DSCR. For example, lenders generally require industrial properties with multiple tenants to have staggered leases so that the property never dips below 1.0x DSCR.
In some situations, if a borrower’s property falls below 1.0x DSCR, or if they lose a major tenant, the loan could go in default, which is something that borrowers will want to avoid at all costs.
In situations where a retail or industrial property only has one tenant, or one major tenant, such as a shopping center with a Walmart, conduit lenders generally require that the lease expires after the maturity of the loan. Otherwise, if the borrower doesn’t have another tenant immediately lined up, or if the property requires a build-out to suit the new tenant, the DSCR could fall well below 1.0x, interfering with the borrower’s ability to make their loan payments and potentially triggering a loan default.