DCR - An Overview
HOW LENDERS LOOK AT DEBT SERVIC
SERVICE
E COVERAGE
As mentioned in NOI - Lenders’ Perspective, lenders have two criteria to determine their maximum loan
amount: loan-to-value (LTV) and debt service coverage (DCR). DCR is simply the ratio of the property’s net
operating income (NOI) to to debt service. If the NOI is, for example, $100,000/year and the debt service
(principal and interest payments on the loan secured by the property) is $80,000/year, the DCR is 100,000
divided by 80,000 or 1.25 (1.25x in lender parlance). Conversely, the lender can determine the maximum
loan amount based on the property’s NOI and the lender’s maximum permitted debt service coverage.
Using the example above, let’s ay the property’s NOI is $100,000/year
and the lender requires a minimum DCR of 1.15x and has an interest rate
of 6.25% and a 30 year amortization:
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•
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Tip:
If you don’t own a financial calculator, go to http://www.rlmtools.
com/ and download their emulator
of the Hewlett Packard HP12C. The
HP12C has been the standard-issue
financial calculator since the early
1980s. If you are not familiar with
how to use the HP12C, email me
and I’ll send you an overview.
$100,000 divided by 1.15=$86,957
$86,957 divided by 12 gives us a monthly maximum debt service of
$7,246
Using a financial calculator, you “back into” the loan amount. Input
$7,246 as the monthly payment (typically input as a negativer number since it is an outflow). Input 360 months for the amortization (30
years amortization times 12 months) and .54167% as the monthly
rate (6.5% divided by 12).
Press the PV button on the calculator and the result will be $1,146,396 rounded
d d to $1
$1,150,000.
150 000
In a second example. let’s say the loan terms are exacly the same except the lender requires a 1.20x DCR.
The only thing that will change now is the maximum monthly debt service which will be $83.333 annually
($100,000/1.20) or $6,944 monthly. Using a financial calculator, we find that this reduces the loan amount to
$1,098,686 rounded to $1,100,000.
Loan Constant: Since the DCR calculation is based on the interest and principal payment (referred to as
a loan constant) rather than just the interest payment, you cannot use the interest rate alone to calculate
your loan amount. Again, using the example above, the interest rate is 6.5%, but the loan constant (k) is
7.585% ($83,333 annual debt service divided by the $1,100,000 loan amount). Since this is an amortizing
loan (level payments over a given period of time with the excess over interest payments going to pay down
principal), the loan constant will go up over time. At the beginning of our fourth loan year, the original $1.1
million loan balance has been paid down to approximately $1,060,000. Since the debt service payments are
unchanged, the loan constant has increased to 7.862% ($83,333 divided by $1,060,000).
How Amortization Period Affects the Loan Amount: The amortization period (number of periods - typically
months - that the loan will be paid off assuming level payments) impacts the loan constant and hence the
loan amount. Let’s say the loan terms are the same except the lender has a loan amortization period of 25
years instead of 30 years. We are still limited to a maximum annual debt service of $83,333 based on the
1.20x DCR requirement. Our inputs into the financial calculator will be the same except for the loan amortization is 300 months (25 years) instead of 360 months (30 years). Now we see that the maximum loan
amount is $1,028,487 rounded to $1,030,000. The loan constant has increased to 8.091% ($83,333 divided
by $1,030,000). Intuitively we know that an increase in the interest rate or a decrease in the amortization
period will reduce our loan amount at any given debt coverage ratio.
DCR - An Overview
Relationship of Loan Constant/DCR and MaximumLoan Amount: As mentioned previously, lenders have
two criteria to determine the maximum loan amount: Loan-to-value and debt coverage ratio. The terms letter
(letter of interest) of a typical apartment or commercial real estate loan will often be written as follows:
Maximum loan amount of $3,250,000 subject to a maximum loan-to-value (LTV) of 75% and a debt coverage ratio of no less than 1.20x.
If we get somewhat esoteric, we can get a sense of whether our transaction is debt service constained or LTV
constrained if we know the capitalization rate of the property we are buying (or refinancing) and the lender’s
minimum DCR and the loan constant.
Step 1: multiply the lender’s loan constant by the minimum DCR. For example, the lender has an interest rate
of 6.5% with a 30 year amortization. Since we don’t know what the loan amount is yet, just use $1,000 as the
loan amount in the financial calculator. The monthly payment is $6.32 per thousand dollars of loan amount,
or $75.85 per thousand dollars annually. Thus, the loan constant is 7.585%. This ratio is unchanged regardless
of the loan amount, of course. Multiply 7.585% times 1.2 (the minimum DCR in this example) and the result is
9.102%.
Step 2: determine the property’s cap rate by calculating the property’s NOI and dividing that by the purchase
price or the property’s estimated value. Let’s say the property’s annual net operating income (NOI) is $150,000
and the purchase price is $2.3 million. In this example, the property is being purchased at a cap rate of about
6.52% ($150,000 divided by $2,300,000).
Step 3: Now divide the cap rate by the DCR adjusted loan constant (6.52% divided by 9.102%). The result is
71.6%. Thus the maximum loan will be about 71.6% of purchase price or about $1,650,000 in this example.
The “breakeven” cap rate is 6.83% (the DCR adjusted constant of 9.102% times the LTV limit of 75%). Therefore, if you buy this property at a cap rate of 6.83% or higher, your loan will be LTV constrained. If your cap
rate is less than 6.83%, it will be debt coverage constrained.
Remember that the net operating income and thus cap rate are based on how the lender/appraiser estimates
the property’s NOI and not necessarily how you as the borrower look at it. Please refer to the NOI - Lenders’
Perspective for further elaboration.