Managing cash flow is a crucial aspect of running any business or investment property. When cash gets tight, it can lead to missed payments, defaults, and even bankruptcy. This is why it’s so important to utilize financial tools that can provide flexibility with cash flow management. One such tool is the interest-only debt service coverage ratio (DSCR) loan.
What Is A DSCR Loan And How Does It Work?
A debt service coverage ratio (DSCR) loan is a type of commercial real estate loan that looks primarily at the property’s cash flow rather than the borrower’s credit score or income. The DSCR calculation determines if the property generates enough income to cover the proposed loan payments.
Lenders determine the DSCR by dividing the property’s annual net operating income (NOI) by the total annual debt service (principal and interest payments). For example, if a property has a NOI of £100,000 per year and total annual debt service of £80,000, the DSCR would be 1.25 (£100,000 / £80,000).
With an interest-only DSCR loan, the borrower only pays the interest each month, not principal. This significantly lowers the monthly payments, freeing up cash flow. The principal balance remains unchanged until the loan matures or refinancing occurs.
How Can An Interest-Only DSCR Loan Help Manage Cash Flow?
Interest-only DSCR loans can provide several cash flow benefits:
- Lower monthly payments – With no principal included, payments are roughly 25-30% lower.
- Flexibility – Interest-only terms allow borrowers to customize payment schedules.
- Reserve funds – The savings from lower payments can be used to establish reserves.
- Refinancing – Interest-only periods allow time to improve property value and refinance.
- Debt consolidation – Can consolidate higher rate loans into a single lower payment.
For real estate investors, the extra cash flow allows more capital for repairs, tenants improvements, or acquiring more properties. Overall, the interest-only DSCR structure helps match loan payments to the property’s current NOI.
What Goes Into Calculating DSCR For Commercial Loans?
When applying for a commercial real estate loan, the lender will closely analyze the property’s debt service coverage ratio. This requires looking at four key components:
1. Net Operating Income (NOI)
This is the property’s income left after subtracting operating expenses. NOI doesn’t include debt service, depreciation, or income taxes. To calculate:
NOI = Gross Rental Income – Operating Expenses
2. Debt Service
This refers to the total loan payments – principal and interest. For an interest-only loan, it would just be the annual interest. Debt service usually excludes reserves and escrow payments. Lower debt service means higher DSCR.
3. Interest Rate and Amortization
The loan’s interest rate and length of amortization period impact the debt service amount. Shorter amortization (e.g. 20 years) means higher payments. Lower fixed rates reduce payments. Borrowers should shop for the best loan terms to optimize DSCR.
4. Loan Term Length
Longer loan terms spread payments out over more years, lowering debt service and increasing DSCR. Interest-only periods also keep debt service low. However, lenders may want full amortization to begin before the loan matures.
Carefully structuring the loan amount, interest rate, amortization, and term length allows borrowers to achieve the highest possible DSCR on a property. This provides more cash flow flexibility.
What DSCR Ratio Do Lenders Look For?
For investment property loans, lenders typically want to see a DSCR of at least 1.20 or higher. However, minimum requirements often depend on other factors like:
- Property type – Multifamily and industrial properties may qualify with a lower ratio than hotels or restaurants.
- Occupancy rate – Highly occupied properties can qualify with a lower DSCR.
- Borrower’s credit – Borrowers with excellent credit may qualify with a lower ratio.
- Loan program – Some loan programs are more flexible than others.
- Amortization terms – Interest-only periods allow for lower DSCR.
- Additional collateral – More collateral can compensate for lower DSCR.
It’s important to discuss DSCR requirements with lenders. Offering a higher down payment or shorter amortization period could potentially offset a lower DSCR.
As a general guideline, here are typical DSCR requirements:
- Excellent – 1.25 and above
- Good – 1.15 to 1.24
- Fair – 1.00 to 1.14
- Low – 0.95 to 0.99
The higher your DSCR, the more assurance you have that the property income can support the loan. Maximizing your DSCR gives you better cash flow flexibility.
How Can You Improve A Property’s DSCR Before Getting A Loan?
If your initial DSCR is lower than desired, there may be actions you can take to improve it before applying for a loan. Some options include:
- Raise rents – If below market rates, consider gradual increases.
- Renegotiate leases – As leases renew, negotiate higher base rent or expense reimbursements.
- Reduce vacancies – Improve marketing and increase tenant retention.
- Add income streams – Offer storage units, parking, laundry, vending, etc.
Reducing Operating Expenses
- Shop insurance and vendors – Get quotes for potential savings.
- Minimize turnover costs – Reduce time/expense between tenants.
- Review staffing – Ensure optimal but not excessive staffing.
- Benchmark expenses – Compare to other similar properties to identify waste.
- Upgrade systems – Improve HVAC, lighting, appliances to save energy.
Improving Cash Flow
- Refinance debt – Lower interest rates to reduce payments.
- Extend loan term – Spread payments over more years.
- Pay down debt – Apply excess reserves to reduce principal.
- Obtain an interest-only loan.
With strategic preparation, it’s possible to increase your DSCR .10 to .20 before getting a new purchase or refinance loan. A higher ratio gives you more options with lenders and better cash flow.
Why Is Ongoing Cash Flow Management Important With DSCR Loans?
Once you’ve obtained a DSCR loan, ongoing cash flow management becomes critical. Property income needs to cover operating expenses, debt service, reserves, and more. Insufficient cash flow can put the property and loan at risk in multiple ways:
Missed Loan Payments
With tight cash flow, preventative maintenance and repairs may be deferred. This can accelerate deterioration and compromise the property’s value.
Inability To Improve Property
Cash flow constraints prevent making value-enhancing upgrades like renovations or adding amenities. The property becomes less competitive.
Lack Of Reserves
Revenue disruptions like vacancies or major repairs can’t be covered without adequate reserves. Owners may need to bring in additional capital.
Lenders and buyers will offer less for a property with tight DSCR and cash flow. It limits financing and sales options.
Ongoing monitoring, budgeting, and management is essential to maintain a healthy DSCR cushion and cash reserves. This provides stability and flexibility for the asset.
5 Strategies For Managing Cash Flow With DSCR Loans
If you secure an interest-only DSCR loan, be sure to implement strategies for effectively managing cash flow:
1. Set Up A Rental Income Reserve
Put a percentage of rental income (e.g. 5%) into a reserve account monthly. This builds a buffer to handle dips in occupancy or rent defaults.
2. Develop An Operating Budget
3. Keep Reserves For Repairs and Maintenance
Estimate annual capital expenditures. Set aside a reserve amount each month (often $200-$300 per unit).
4. Monitor DSCR and Loan Terms
At least quarterly, recalculate DSCR based on current NOI. Ensure you’re meeting requirements. Be aware of upcoming rate and term changes.
5. Have a Cash Flow Contingency Plan
Identify options if cash flow tightens, like deferring certain expenses, gathering additional investor capital, or refinancing.
Conservative financial management ensures DSCR loans remain an effective tool for unlocking cash flow potential in investment properties. Monitoring key metrics allows you to make proactive decisions and optimize results. With proper diligence, interest-only DSCR loans provide a flexible base for your real estate portfolio.