Pre-Planning to Avoid the Debt Service Coverage Ratio Covenant Default
Experienced borrowers know that the most important factor a lender looks at in underwriting a loan is the borrower’s ability to repay. Certainly, the value of the collateral is important. However, lenders aren’t in the business of owning and operating real estate or other assets. So, while loan to value (LTV) is important, it is never the sole factor in loan underwriting. Lenders want to be repaid.
The borrower’s and guarantor’s net worth, as shown on their financial statements, becomes very important. Does the buyer have the financial strength to repay the loan? Do the guarantors? Again, this is an important consideration, but it is not taken in a vacuum. Loan payments are made monthly. Borrows don’t borrow money with the intent of repaying it with their assets. Equity is generally funded up front. Loan payments are supposed to be made through the cash flow of the property or the business. Therefore, lenders must be certain that the property or business can generate enough revenue to cover all of its expenses and repay the loan. Accordingly, most loan commitments will contain a Debt Service Coverage Ratio (DSCR) requirement and a DSCR covenant will be added to the loan agreement.
DSCR is a simple calculation. Lenders generally use one of two formulas expressed as follows:
- EBITDA / (Current Maturities of Long Term Debt + Interest)
- NOI / (Current Maturities of Long Term Debt + Interest)
Depending on the type of business or property, lenders will require that the DSCR be maintained ranging from 1.2 to 1.5 or higher. If the targeted DSCR is 1.2, the property or business creates 20% more income than it needs to make its loan payments.
What should a borrower be concerned about when seeking a loan as it pertains to DSCR? How a lender reviews DSCR could affect whether a loan is in good standing. If the target is not met, a lender may have the right to declare a loan default or have the right to require that borrower make principal reductions to bring the loan into compliance. Be aware that distributions to partners or shareholders, even salaries paid to owners could affect DSCR unless permitted under the loan agreement or specifically excluded in the NOI calculation.
Borrowers should make sure that the lender does not have the right to review DSCR more often than annually. Cash flow in certain businesses or types of properties ebbs and flows, such as hotel. Frequent DSCR reviews could cause default because of a poor cash flow time period even though the annual test would show the borrower meets the target.
It is a good idea to negotiate the DSCR target as close to 1.0 as possible. This needs to be done at the commitment stage as it is an underwriting issue and a key basis for making the loan.
As a remedy for missing a DSCR Target, rather than default or principal pay down, offer to escrow cash as additional collateral until the next review. Another solution would be to request a new appraisal of the property. If the appraisal exceeds x% of the mortgage, the DSCR covenant would not apply. These solutions are particularly important early in the loan term as the underwriting is usually based on pro-formas that have been prepared by the borrower and adjusted by the underwriter. Sometimes, the business or property needs more seasoning.
Technical loan defaults are the hardest to cure. The DSCR covenant is among the easiest to breach and the hardest to cure. Borrowers need to plan for DSCR prior to making a loan application. The planning should to include strong, but realistic pro-formas and a strategy for negotiating with the lender for a fair DSCR loan covenant. This planning can help to avoid default problems during the loan term.