Debt service coverage explainedScott SmithDebt service coverage
The most important aspect of underwriting an income-producing
property is the debt service coverage. An acceptable debt service
ratio varies from institution to institution and is typically
between 1.10x's and 1.25x's. Debt service is defined as the amount
of cash flow available to meet annual principal and interest
payments on debt—the higher the debt service, the better. A
debt service of 1.00x's is a break-even cash flow. When a broker
submits a package to a lender, it is beneficial to include a debt
service calculation so that the lender knows how the property cash
flows up front. This greatly increases the amount of time it takes
for a lender to get back with an answer. A quick "no" allows the
broker to move on to another lending source if the debt service
does not meet a lender's criteria.
When calculating the debt service, start by adding up all of the
rents received from the subject property. If the property is
vacant, an estimated market rent should be used. This figure is the
gross potential income. From this, a vacancy factor must be
considered. Lenders insist on a vacancy factor, regardless of the
property's current rent roll. The property type, location of the
property and the number of units will determine a reasonable
vacancy. An acceptable vacancy can range from five percent to 20
percent, based upon the aforementioned factors. The resulting
figure is known as the effective gross income (EGI).
The EGI, minus all operating expenses associated with the
property, will determine the net operating income (NOI). Expenses
on a property include real estate taxes, insurance, maintenance,
water/sewer and utilities. If an outside management company managed
the property, that fee would be deducted here, as well. If this fee
were unknown, an estimate would be around six percent of the EGI. A
reserve should be taken for replacement of the roof, HVAC and other
capital costs. The reserve can range from two percent for new
construction to 10 percent for an older building that will need
attention in the near future.
The NOI is the cash flow available to service the proposed debt.
Divide the NOI by the proposed principal and interest payment. Do
not include taxes and insurance in the proposed debt; they have
been included in the operating expenses. The result is the debt
service coverage. This figure is the key component to most lenders.
Lenders will rely on the income of the property to repay their
loan. They believe that the property should be able to support
itself without additional monies from the borrower. It should be
noted that a lender might grant the loan if the debt service does
not meet its requirements. The lender can justify granting the loan
if the borrower has significant income and can afford the
additional out-of-pocket costs. A personal debt ratio will
determine the borrower's ability to do so. The lender may also
require additional collateral. If the lender chooses to do this, it
is noted as a policy exception and must be disclosed to the
approval authority. An acceptable debt service coverage will avoid
these measures, increasing the potential to close the deal.
The appraisal that is ordered by the lender will include the
income approach to value, as well as the sales comparison and cost
approach. The rents and expenses utilized in the underwriting
process will be verified in the income approach. The lender will
use these to calculate the debt service.
Also keep in mind the need to submit the leases for the subject
collateral in your initial package. Lenders will look at the term
of the lease if there are any options to extend and any
reimbursements due to the owner.
Scott Smith is a senior lender at Southampton, Pa.-based
Gelt Financial Corporation. He may be reached at (800) 355-4358,
ext. 225 or e-mail firstname.lastname@example.org.