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What does a foreign investor contemplating taking out a bank loan need to know about Debt Service Coverage Ratio (DSCR)?

My company is evaluating purchasing a residential multi-family property outside of Miami valued between $100-$125 million to our U.S. portfolio. We have invested in the United States before – in a senior living property outside of Dallas. As a Chinese developer, we have funds currently tied up in other developments and would like to take out a bank loan for part of the cost of the new acquisition. We understand that lenders may calculate DSCR in different ways. We have little debt, but what should we be aware of before speaking to banks?

  • Seyfarth Shaw LLP
    February 09, 2018

    DSCR refers to the amount of cash flow available to meet your payments on the debt. The ratio is how banking determines the debt servicing ability. A DSCR of less than 1 is indicative of a negative cash flow, signaling that the borrower will not be able to make its payments, without obtaining funding from outside sources. As a result, a DSCR of greater than 1 means that the borrower has sufficient income to pay its current debt obligations. Given that you're cash rich with little debt, lenders should be eager to speak with you. Good luck with your venture!

  • SPC Advisors, LLC
    January 11, 2018

    Your question is a good one. The answer is nuanced based upon the type of entity you are borrowing from, the loan-to-value and the vacancy percentage. I would love to have the opportunity to work through this with you. The first thing I would tell you is that, if this is the first time you are borrowing money in the US, all financial institutions will want to do a thorough review of the source of your funds (whether from the PRC or elsewhere), your compliance with the Patriot Act and the regulations called "kyc," or “know your customer,” which vary from institution to institution. They will want information about direct and indirect owners, for example. Now to your question. Debt Service means, for a specific period of time, the amount of scheduled interest payments due and payable under the Note. Debt Service Coverage Ratio consists of a ratio, as determined by lender, for the applicable period, in which the numerator the Underwritten Net Cash flow for the trailing (12, for example) month period immediately preceding the date of determination; and the denominator is the aggregate amount of principal and interest under the loan (if only a senior loan) based on assumed constant rate, which will be negotiated. Read carefully because a lot of negotiation goes into the definitions. For example, Underwritten Net Cash Flow will likely take into account vacancies, when income from a lease can be counted (during a free rent period?). You will want measurements to be taken annually (maybe with a stub period if there is an initial lease-up period). If you are fixing the interest rate, it should be easy to derive a constant rate. I hope this is a helpful starting point and look forward to working with you.

  • Ching & Seto, APC
    January 16, 2018

    Debt Service Coverage Ratio is just a way for banks to measure your cash flow to determine if you have the ability to cover the debt repayment. Anytime you apply for a loan, you will need to provide documents showing the company's financials. Make sure you have your profit and loss statement ready, together with balance sheets and tax returns. You want to make sure your net income is positive to show you have the ability to pay the debt. Speak with your accountant to determine what is your current cash flow and make adjustments accordingly. Banks like to see at least 2 years of positive cash flow before agreeing to any type of loan.

  • Black Creek Group
    January 19, 2018

    Standard DSCR is 1.2X or more. It is pretty straightforward.

  • Chair, Real Estate and Financial Services Department, Polsinelli
    January 20, 2018

    Lender DSCR requirements do vary and can range from 1.25 to 1.90 depending on the overall underwriting analysis. We looked at some random ones on recent deals in our files from non-"agency" lenders (see below) on multi-family properties and they were all at 1.50. Since this a multi-family property, the odds are that you will end up with a loan from one of the "agencies" (Fannie Mae or Freddie Mac). The standard baseline for originations is a 1.25 DSCR. It can be higher or lower in various circumstances, which will likely affect the pricing. Carefully analyze the definitions used in the formulation. For example, one thing to watch for is whether the document calls for "underwritten" or "actual" net cash flow (for example, even if the borrower does not retain a third-party property manager, the lender will deduct a "market" management fee). You will want to know what items the lender will want to deduct in the "underwritten" net cash flow situation.

  • Greenberg Traurig, LLP
    February 09, 2018

    There are several metrics that typically applies when US lenders are underwriting a real estate loan. First is the loan to value ratio, which I take it, you already understand as the ratio of the loan amount to the value of the property at the time the loan is made, usually based on a formal appraisal done by an MAI appraiser acceptable to the lender. Second is the DSCR which is the amount of coverage from Net Operating Income (ie gross income in excess of operating expenses) over debt service payments. Usually DSCR is a static calculation done at the time of loan origination and based on in place rental income, often after assuming a certain level of vacancy even if a property is fully leased (often 5%, but this can vary by property type and market) over underwritten operating expenses for the property (normal property level operating adjustments, usually excluding capital expenditures, for which the lender will often require a cap ex-reserve from the loan proceeds at closing), are made by lenders after evaluating the expenses of the property to make them more realistic to what the lender anticipates may add to operating expenses based upon their experience, the borrower's business plan, replacement reserves, etc.). This is usually a static evaluation based upon NOI at loan origination but can be further adjusted for leases about to roll over or other things that might affect the borrower's ability to cover its debt going forward. Occasionally, there will also be DSCR covenants in a loan going forward where the lender may require a full cash sweep of all property cash flow at any time over the course of the loan where there is a "trigger" event, which will usually be related to a vacancy, decrease in cash flow or other things affecting the borrower's ongoing obligation to pay debt service. You should ask for clear guidelines on the lender's underwriting standards before going too far down the road so you fully understand the requirements and how they may affect the loan, both at closing and during the term, and select the lender and loan that affords the most flexibility and imposes the least in the way of constraints, like a cash sweep. Usually, a more highly leveraged loan, given the greater risk, will have more onerous constraints and requirements for all of these items.

  • Polsinelli
    February 08, 2018

    DSCR or Debt Service Coverage Ratio is a common performance metric in stabilized real estate. Sometimes a minimum DSCR is a requirement to close the loan and in others it is a requirement to close the loan and/or an ongoing covenant. Sometimes DSCR will also be a pre-condition to extending a loan. The lender's concern here is that the property is maintaining its underwritten level of performance. Borrower should not agree to permit a DSCR failure to constitute a default under an otherwise performing loan. The counter is to sweep all cash from the property until the property is once again achieving the agreed upon DSCR. The advantage is that by sweeping cash, the lender is adding additional security to its position. Sometimes lenders will use the excess cash flow to pay down its loan, but this does not work where the loan rate is fixed and is subject to yield maintenance or defeasance - this would work with a bridge loan where the lock out period has past, but beware that if there is a swap in place to fix the floating rate, prepayment may cause breakage if the swap is out of the money. As far as calculating DSCR, push for DSCR to be calculated on a portfolio basis of the acquisition - not all your assets. This allows stronger performing properties to bolster the performance of sub-performing properties. Also negotiate for the right to pay down the loan if necessary (and sell properties, if necessary) without yield maintenance, exit fees, etc. to achieve the requisite DSCR and if the loan is otherwise performing you should never agree to DSCR covenant failure to constitute a default, but at most require a cash sweep of excess cash flow to a lender controlled lockbox. Please let me know if you have any comments or questions.