What Is DSCR & Why Is It Important?

One important metric operators use to assess the viability of a real estate investment is the Debt Service Coverage Ratio (DSCR).

The DSCR gauges whether the property generates enough income to meet its debt payments comfortably.

It's calculated by dividing the property's net operating income by its total debt service.

Why is it important?

Risk Assessment: (Crucial) DSCR provides insight into the risk associated with a property. A higher ratio indicates that the property generates sufficient income to cover its debt obligations, implying lower risk for lenders and investors. Need to account for downside scenarios here and make sure you’re able to withstand a substantial decrease in rents in the event of a downturn.

Lender Requirement: Lenders use DSCR as a criterion for loan approval. They need ratios above a certain threshold to write the loan and ultimately make sure they won't lose their shirt.

Decision-Making: For investors, DSCR is a variable in determining the profitability and stability of an investment. Higher ratios indicate you have a better ability to take on pain.

Things to consider:

Thresholds: Ideal ratios vary based on location, property type, and market conditions- a ratio of 1.25 or higher is generally considered favorable for multifamily properties.

Underwriting Standards: Lenders have specific criteria and will analyze the property’s income sources, vacancy rates, operating expenses, etc. Need to have tight, conservative underwriting and familiarize yourself with their process.

Operational Efficiency: Improving DSCR doesn't always mean increasing rental income. Tightening expenses will improve this number- shop out your insurance policies, preventative maintenance, not planting sod, etc.

The DSCR ratio informs portions of your due-diligence process, helps assess downside risk, and sheds light on the performance of the asset.

Market Triangulation

"Market Triangulation" – involves examining a market from multiple perspectives to confirm trends, identify opportunities, and mitigate risk.

Here's how you can apply this method effectively:

Data-Driven Analysis:

1.) Gather local real estate listings (both for sale and pending) for your asset class and sales records/parcel maps from the local tax assessor (within the last 24-36 months, we dive deeper and pull 10+ years of info).

Parcel and zoning maps will often provide the community organizations or historical societies that govern these areas.

How have property values changed over years?

How have building types changed?

What are the zoning classifications, how do they differ?

Where are the historic districts, who governs them?

Some sub-markets change faster than others- many underlying factors to account for here.

Look at geographies and the concentration of buildings in each area.

How do densities differ between neighborhoods?

Which areas appear to be more walkable than others?

What type of terrain will you be dealing with?

These numbers are important but need to overlayed with many other factors to have substance.

2.) Source economic indicators (market-based vacancy, historical rent trends, employment numbers, etc.) from census data, brokerages, neighborhood publications, etc.

How have rental rates changed over time?

What areas have higher vacancy rates than others?

Where are the employment centers?

Have legislative policies affected these real estate markets?

What’s the prevailing industry or industries in this location?

How has economic growth changed over the years?

3.) Dig into demographics.

Where are the affluent areas?

What areas are working class?

What populations are moving in or out of certain areas?

How do incomes differ?

How do crime statistics differ across locations?

4.) Local expertise and community engagement:

On-the-ground insights provide invaluable information about neighborhood dynamics and emerging trends.

More importantly, they’ll allow you to check your work while cultivating necessary relationships.

Every long-time resident of an area will have their insights on it.

We need to source as many of those as we can.

Talk to brokers, property managers, local construction companies, etc.

It’s as important (if not more) to talk to the people who are operating the city- the bartenders, the servers, the coffee shop employees, barbers, etc.

That beautiful 10 unit apartment complex you thought you liked?

A local might say, “Oh, that’s in the X corridor, they’ve been trying to attract people there for years. My favorite store went out business on the same street and the owners haven’t been able to fill that vacancy in 3 years.”

-You learned that there’s no foot traffic here (even if the property looked centrally located on a parcel map)

-Anytime you need to attract people to a location, it raises questions.

With more reps, you’ll be able to check off certain areas from your list and slowly refine your understanding of the market.

Nailing Overhead

Gathering operating expenses can be tricky when entering a new market and vary greatly depending on the location of the asset.

Everybody needs to pay their property taxes, insurance, maintenance costs, common area utilities, and budget for cap ex- but how do you gather firm estimates of these expenses to inform your underwriting?

Property Taxes- Your real estate brokers will have estimates on this, these can range from 1-2% of the property's purchase price. You won't pay the same rate as the current owner- need to make sure you have a tight projection of what these future taxes will be.

We also like to review all of the information on the the local tax assessor's website. If we have any questions, we'll call them to get further context.

These are often nice conversations with somebody who has likely lived in that city for a long time- great opportunity to ask about their experience.

Insurance- Collect references from your real estate brokers, lawyers, lenders, and/or do a quick Google search for commercial insurance brokers in X city. From here, find their website (make sure they're properly licensed and credentialed), reach out, and start to dig into their approach.

How responsive are they? Who would be your main point of contact? How do they structure policies for your asset type? What do their claims processes look like? What information do they need to pull quotes? What is the timeline to receive quotes? How many years have they worked in this market? Will they fight to save you money when possible?

Gather these inputs and then send over 2 sample listings for quotes. You're looking to nail down the costs to insure the asset and for variations in pricing across the brokers.

After pulling enough quotes, you'll have a firm idea of insurance costs and will hopefully have a great broker informing these inputs.

Maintenance Costs- Vary based on the property condition and market. These are often handled by your property management company (who can assist in finding these costs) but will be billed back to you. Important to account for both recurring and unforeseen maintenance costs.

Garbage Removal: In many cities, owners of buildings with more than 4 units need to hire a private garbage removal service. These can range from $75-$500 a month depending on the size of the complex. Broker referrals, a quick google search, or P&L's provided by sellers (which can list the name of the servicer) will provide options. Contact them and get pricing.

Snow Removal/Landscaping: Same process as the above

What preventative maintenance is needed?

Annual MEP inspections- who provides these and what do they cost? Ask your PM.

Who's replacing the air filters each quarter? Nail down every cost you can foresee. 

Common Area/Owner Paid Utilities: Listing P&L's and brokers can provide color- back in to what these cost on a monthly basis (make sure you blend these across 12 months, summer usage can be different than fall usage, be very cognizant of meter counts).