Why you need to care about DSCR
Updated: Aug 4
There are a few metrics that give a strong hint of the quality of a deal in a single number. DSCR is one of these metrics. DSCR stands for Debt Service Coverage Ratio. DSCR describes how well a property can cover its debt. DSCR is calculated as follows:
DSCR = NOI / Debt Service
For example, a property with a DSCR of 1.0 can cover its expenses and debt, with no profit (break-even).
$50,000 NOI / $50,000 Debt Service = 1.0 ( Break-even )
A property with a DSCR of 1.5 means that the property pays for all expenses and debt, with a 50% extra afterward.
$50,000 NOI / $33,333 Debt Service = 1.5 ( $16,667 Profit )
A property with a DSCR of .90 means that there is not enough income to cover expenses and debt.
$45,000 NOI / $50,000 Debt Service = 0.9 ( $-4,500 Loss )
DSCR is important because it is a measurement of a property's ability to pay its debt. In a way, DSCR is a snapshot of how healthy an asset is running. The higher the DSCR, the more cushion and profit the property makes. Traditional banks and government agencies like to see a DSCR of 1.2. This means the property is able to cover its debt plus have 20% extra in case of the unexpected such as higher vacancy, a cap-ex issue, or heightened repair costs.
Although traditional long-term financing requires a 1.2 DSCR, this does not mean property should not be purchased below that. On the contrary, distressed property may have a negative or low DSCR at purchase but when stabilized, it would be at 1.2+. These business plans are common and require cash purchase or a bridge loan to purchase the property until the property is stabilized at which point it will be refinanced into long-term debt or sold. These situations happen with mismanagement, high vacancy, or even very low rents.
The key in low or negative DSCR purchase situations is evaluating the business plan. As a limited partner, you do not need to create the business plan, however, you should talk to the sponsor/GP to make sure their business plan seems realistic and makes sense. If the DSCR is low or negative, adequate reserves should be in place to cover this shortfall. Cashflow is the life and blood of an investment, if there is not much or none while stabilizing, there must be plenty of reserves.
DSCR is a great metric to keep a pulse on the project throughout its life. It is imperative to evaluate during purchase to understand its current performance, and each year to see how a property is improving.