A Debt Service Coverage Ratio (DSCR) is a measure of risk often used by real estate lenders to assess the risk of a particular loan or portfolio of loans. A DSCR measures the ability of a real estate asset to cover its debt service requirement. The calculation is made by dividing the Net Operating Income (NOI) by the amount of the debt service. NOI is defined as the income generated from a real estate asset minus the operating expenses necessary to operate the asset, but before the deduction for debt service, depreciation, and taxes. Debt service is defined as the periodic payment to service the debt.  If an annual NOI is to be used in the calculation, match the debt service by using the annual amount. Let’s take a look at the calculation (where N is the number of loans secured by the asset or portfolio):

A DSCR of 1.19 tells us that the asset’s debt service is being covered with enough income left over to cover an additional 19% of debt service. Notice that the monthly payment of Loan 1 was multiplied by 12 to arrive at an annual amount. The $23,250 of debt service for Loan 2 is already an annual amount.  The NOI was also stated as an annual amount.

Let’s take a look at how DSCR might change over time. The chart below tracks the DSCR of a real estate asset that is secured by two loans. The first position loan is a constant payment with a fixed interest rate and a the second position loan is interest only payable monthly with a variable interest rate floating on Prime with a 5% floor.

Let’s see what we can learn from the chart.

• In the beginning of the year in 2008, the asset was not covering its debt service. There was not quite enough NOI to cover its debt service with a DSCR of about .99.
• As the Prime rate was falling during 2008, it began to better cover its debt service because the debt service on the 2^nd position loan was falling inversely with Prime until the 2^nd position loan hit its interest rate floor of 5%.
• NOI increased between 2008 and 2009 and the DSCR leveled off. It’s now barely covering the debt service with a DSCR of about 1.04.

The question is: Do you know the Debt Service Coverage Ratio for each of your real estate assets and for your entire portfolio of real estate assets? Calculating the DSCR for each of your real estate assets can be time-consuming and the calculation keeps changing over time as your debt balances change and the NOI changes. Fortunately, with loan software you don’t need to be a mathematician or hold an MBA to calculate your own DSCRs. Your loan transactions can be initiated from within the system and automatically imported into your other financial systems. By maintaining current loan balances and current interest rates in the debt management system, you can calculate the DSCRs for each of your assets and portfolio and much, much more at the touch of a button. For more information on loan and asset organization and Portfolio Debt Manager, visit http://www.portfoliodm.com/.

For additional information about this and other topics contact Ledgerwood Associates.

In the practice of real estate finance, lenders have a few choices on how to calculate the interest charged to their borrowers. In this article, we will explore the cost differences and the effective rates of three common types of interest calculations:  360 / 360, 365 / 360 (Bank Method), and the 365 / 365 (Stated Rate Method). The first number represents the number of days in the compounding period for which interest is to be charged. For 360, interest will only be charged on 360 days of the year. If the loan calls for a monthly compounding period, interest will be charged on a 30-day month regardless of the number of actual days in the month. For 365, the loan calls for interest to be charged on the actual number of days in the compounding period. The second number represents the number of days in the year to divide the Annual Percentage Rate by. For 360, the stated interest rate is divided by 360. For 365, the stated interest rate is divided by 365.

 To illustrate the differences, let’s use an example lending commitment. The table below sets out our assumptions:

When we amortize each interest type to maturity and sum up the total interest that would have been paid over the life of the loan, we find that the lifetime interest paid for each type in the table below:

The most advantage interest calculation type to the borrower is the 360 / 360 followed closely by the 365 / 365. The 365 / 360, when amortized over the 360 term periods, will cost the borrower an extra $37,460 (3.746% more) when compared to the 360 / 360 interest type. Next let’s determine at what effective rate will cause each alternative to have the exact same lifetime interest cost. The results are shown in the table below:

If a borrower is evaluating a financing proposal from a lender which charges interest the actual number of days dividing the stated interest rate by a 360 day year (365 / 360), the stated interest rate must be equal to or lower than 4.92853% to make it comparable or advantageous to the borrower when compared to the 360 / 360 interest calculation type. The 365 / 365 type is virtually identical to the 360 / 360 interest calculation type.

In this example, we used a 30-year amortization term period. If the loan calls for a shorter term, say 10 years, the effective interest rates remain the same and the interest cost of the 365 / 360 loan will again cost the borrower an extra 3.746%.

This analysis was prepared in a matter of minutes using the Comparative Finance module of Portfolio Debt Manager (PDM). To better understand your loans and their effect on the assets by which they are secured, loan management software like PDM can be invaluable. You can project the balances of your loans forward in time even if they have graduated payment types. Additionally, you can view the debt of your real estate assets, consolidate your asset debt to the portfolio level, and track it over time. Every piece of information on your loans can be accessed with the click of a button.   To learn more about interest calculation methods and Portfolio Debt Manager, visit www.portfoliodm.com

For additional information about this and other topics contact Ledgerwood Associates.

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