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In multifamily and/or BTR-SFR syndicated real estate investment, debt financing, obviously, plays a very important role. Having an appropriate amount of debt can leverage or magnify investment returns of the equity for the benefit of the investors. However, it is also important to ensure that the debt part of the total investment is not excessive and that repayments to lenders can be met even if cashflows change..
There are several financial metrics in use which can help assess the relationship between income from the property and the amount which needs to be repaid to the lending entity and this week we will take a look at one of the most well-known metrics, namely the Debt Service Coverage Ratio.
What is the Debt Service Coverage Ratio (DSCR)?
The DSCR is a critical financial metric which is used to assess the ability of a real estate investment property to generate enough cash flow to cover its debt service obligations. It is a vital tool for real estate investors to determine the financial feasibility of a potential investment opportunity, as it provides a measure of the property’s ability to generate income and pay off its debt.
How is the DSCR calculated?
The DSCR is calculated by dividing the property’s net operating income (NOI) by its debt service. The NOI is the income generated by the property after operating expenses and before debt service payments are made. The debt service is the total amount of principal and interest payments on the property’s outstanding loans.
For example, if a property generates an NOI of $100,000 per year and has a debt service of $80,000 per year, its DSCR would be 1.25 ($100,000 / $80,000).
A DSCR of 1.0 indicates that the property’s net operating income is equal to its debt service payments, meaning that it generates just enough income to cover its debt obligations. On the other hand, a DSCR greater than 1.0 indicates that the property generates more income than it needs to cover its debt payments, whilst a DSCR less than 1.0 suggests that the property may struggle to generate sufficient income to cover its debt obligations.
Naturally, lenders and investors typically prefer properties with higher DSCRs, as they provide greater assurance that the property will generate sufficient cash flow to cover its debt obligations. A high DSCR indicates that the property is generating ample income to cover its debt, which reduces the risk of default and increases the likelihood of steady and predictable cash flow for the investor.
In general, in multifamily real estate syndications, a DSCR of 1.2 or higher is considered good, whilst a DSCR of less than 1.0 is considered risky.
Why is DSCR important?
The DSCR is a particularly important metric for investors who are considering purchasing an investment property with financing. In most cases, the lender will often require a minimum DSCR as a condition of the loan. The lender wants to ensure that the property generates enough income to cover its debt service payments and minimise the risk of default.
For example, if a lender requires a minimum DSCR of 1.25, a property with an NOI of $100,000 per year and debt service of $80,000 per year would need to have a minimum NOI of $100,000 / 1.25 = $80,000 per year to qualify for the loan.
If the property cannot generate sufficient income to meet this requirement, the lender may require a higher down payment, a higher interest rate, or even reject the loan application altogether.
Other financial metrics in use apart from DSCR
The DSCR is not the only financial metric used by real estate investors and lenders to evaluate investment opportunities, but it is an essential one. Other financial metrics that are commonly used include the capitalisation rate (cap rate), internal rate of return (IRR) and return on investment (ROI).
Just for comparison, the cap rate is the ratio of the property’s net operating income to its current market value. It provides an estimate of the property’s potential return on investment and is useful for comparing different investment opportunities.
The IRR is a measure of the total return generated by an investment over its holding period, taking into account both income and capital gains. It is a more complex metric than DSCR and requires forecasting of future income and capital gains, but it provides a more comprehensive view of the investment’s potential return.
The ROI is the ratio of the investment’s net profit to the amount invested. It is a simple metric that is useful for assessing the profitability of a particular investment opportunity.
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CPI Capital uses a variety of financial metrics when assessing and evaluating potential investment opportunities in the multifamily and/or BTR-SFR sectors. Clearly, some of these metrics are more detailed than others but using such simple metrics in the initial stage of project assessment can help eliminate some potential projects and enable us to focus in more detail on those where the potential for investment returns is greatest.
Whilst each of the aforementioned financial metrics provide valuable information about a potential investment opportunity, CPI Capital see DSCR as particularly important for assessing the property’s ability to generate sufficient income to cover its debt service.
CIO, Co-Founder CPI Capital