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 [email protected].
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