How to Navigate the Real Estate Eviction Process

How do you feel about a criminal conviction on your record? Defending against a civil suit for intentional infliction of emotional damage? They don’t sound too bad? Well, how about a fistfight with a tenant on the front lawn of your rental property?

If you’d prefer to avoid these scenarios, it might be a good idea to understand the process required to lawfully evict a tenant. While the details of the eviction process vary from state to state, the general principles discussed here are almost universal. We’ll take a look at:

• Why a landlord should avoid “self-help” evictions
• The eviction process, from soup to nuts, including:
  • Termination of tenancy notices
  • Filing the eviction suit and serving a summons
  • A tenant’s answer and possible defenses
  • Trial and judgment for possession and/or damages
  • Sheriff’s eviction and dealing with property left behind
• Differences between residential and commercial evictions

Can’t I Just Change the Locks?

When a tenant isn’t playing by the rules, when they’re behind in their rent payments, consistently violating lease obligations, it can be extremely frustrating for a landlord. For many there is a desire to just take care of the problem themselves, and figure out a way to get the tenant to leave.

These so-called “self-help” remedies (evicting without using the proper eviction process) include such things as:

• Changing the property’s locks
• Turning off utilities to the premises
• Harassing and threatening the tenant
• Removing the tenant’s personal property

These can seem attractive in the short term because they seem quicker and less expensive than a court action. However, because they’re illegal, and often dangerous, in the long-run “self-help” actions can end up being far more time-consuming and costly than simply following the statutory procedure.

Almost every state prohibits a landlord from using self-help methods, and may impose penalties for such, including allowing tenants to remain in possession of the rental property. Further, if a landlord uses these it can be sued for, among other things, trespass, harassment, wrongful eviction, invasion of privacy and intentional infliction of emotional distress. These suits can seek damages caused by the landlord’s unlawful behavior, including not only actual damages (e.g., the cost of a hotel room while the tenant was dispossessed, food gone bad when electricity was turned off, replacing personal property “lost” when the landlord entered the property, etc.) but also punitive damages.

Fighting these types of suits could take years and tens of thousands of dollars. Losing them could be even more costly. The alternative, however, following the statutory eviction procedure, virtually eliminates these hazards.

That being said, let’s take a look at the process.

Eviction Process

Let’s take a look at the eviction process, step by step.

Step 1: Notice of Termination of Tenancy

Before beginning down the path of an eviction, one must understand that because removing a person from their home is a significant event, the courts will require strict compliance with their eviction laws. This means meet the notice deadlines. Serve the notices in their proper fashion. Name the proper party, etc. If a landlord fails to follow the rules, even the little ones, their action will be delayed.

The first step in the process is the landlord serving its tenant notice that the tenancy is being terminated. The method of service (i.e., its delivery) will be set forth in the state laws, but generally involves methods like personal service to the tenant (hand-delivery), leaving notice at the property with a person of at least a minimum age, or being sent by certified mail to the property.

Termination Notices for Cause

The notice explains why the landlord is terminating the tenancy, and will fall into one of two categories: (1) termination for cause or (2) termination without cause. Termination for cause means the tenant has failed to meet one or more of its obligations under the lease. The most common failure is not paying rent. Based on the type of default, there are three types of termination notices for cause: (a) pay rent or quit, (b) cure or quit, and (c) unconditional quit.

Pay rent or quit notices notify the tenant they owe rent, how much they owe (including penalties), and when they must make full payment. They have the choice of either paying this amount by the date specified or leave (“quit”) the premises. If they pay, the landlord will stop pursuing eviction. If they do neither, the landlord can then proceed with the eviction process. However, not all states require a pay rent or quit notice. For example, in New Jersey, a landlord can file an eviction complaint for failure to pay rent without first giving his tenant any notice.

Cure or quit notices tell the tenant they have breached one or more of their duties under the lease, and gives them an opportunity to fix (“cure”) the breach. For example, if the lease limited the number of occupants to two, and there were four residents, the tenant could cure by having two people move out. If the tenant doesn’t timely cure, and doesn’t quit, the landlord can proceed with the eviction process. A cure or quit notice should be specific about the breach, and how it can be cured, so the tenant has an opportunity to avoid eviction.

The third “for cause” termination notice, an unconditional quit notice, notifies the tenant that is in breach of one or more lease terms, but has no right to cure. They simply must quit the property by a certain date or an eviction action will ensue. The general thought is that because this is a harsh outcome it should only apply to serious transgressions such as repeatedly failing to pay rent on time, violating significant lease terms, or engaging in illegal activity on the premises. However, not all states agree, and in some cases an unconditional quit notice can be used where other states would require a pay rent or cure notice.

Termination Notices Without Cause

In some cases a landlord may have the right to terminate a lease even where the tenant has done nothing wrong. A typical example is a month-to-month lease, where termination can occur for no reason so long as the tenant is given a 30-day notice. Of course, each state has its own peculiarities. For example, in New Jersey, if a tenant lives in a rental property with three or fewer apartments, and the landlord occupies one of the units, then the landlord doesn’t have to establish any cause for eviction.

Special rules may also apply to publicly or federally-subsidized housing such as Section 8, HUD Housing or the Low-Income Housing Tax Credit (LIHTC) program. For example, landlords cannot evict tenants in LIHTC units without giving notice of specific “good cause” reasons. Good cause is determined on a case-by-case basis, though it may include serious or repeated violations of the lease, crime or drug related activity, or failure to vacate following a condition that leaves the unit uninhabitable.

Step 2: File Eviction Action

If the tenant was unresponsive to the termination notice, a landlord may file a “complaint” for eviction with the court. Generally this suit is referred to as an unlawful detainer action. The complaint is the pleading that starts the eviction suit and notifies the tenant of (1) the basis for the court’s jurisdiction, (2) a statement of the eviction claim, (3) the relief being sought by the landlord (e.g., rent, possession, damages), (4) why the landlord is entitled to this relief, and (5) a demand for judgment.

The landlord must serve (in compliance with the state’s laws as to who can serve, and how they must serve) the tenant with a copy of the complaint and a summons. The summons is the official notice that the eviction action has been filed, and generally includes the case number, which court will hear the case, when the tenant must respond to the complaint, and the name of the landlord’s attorney.

Step 3: Tenant Answer and Defenses

The tenant may file an “answer” to the allegations in landlord’s complaint, denying the complaint’s claims, and asserting any defenses it has to the action. The answer must be filed within the time described in the summons.

A common response to a complaint is that the landlord failed to follow the procedural eviction rules in some fashion, e.g., termination notice was improperly served, the complaint named the wrong party, etc. While such responses are easily cured, each failure can add weeks to the eviction process. These responses are typically delay tactics more than defenses, but can be leveraged to negotiate a settlement with a landlord who would like to regain possession of his property sooner rather than later.

Other common defenses include that (1) rent was paid in full prior to filing of suit, (2) landlord failed to maintain property in a safe and habitable state, or failed to comply with all building codes, (3) the eviction is discriminatorily based on race, religion, gender, national origin, familial status or disability, (4) the landlord used impermissible self-help actions, (5) the eviction is retaliatory, and (6) the tenant used rent to offset the cost of repairs it made when the landlord refused to do so itself.

One interesting tenant’s defense is the claim of a “constructive eviction.” This occurs where a tenant alleges that landlord’s failure to take some act (e.g., repair a leaky roof) substantially interferes with or permanently deprives a tenant from using the property. If successful on this claim, a tenant doesn’t have to pay for rent during the period of interference, though most jurisdictions will require the tenant to vacate the premises (you can’t stay if you just proved the property is uninhabitable!).

Step 4: Trial and Judgment

The court will set a date for trial following receipt of the tenant’s answer. If the tenant failed to answer, the court will award a default judgment and the relief landlord sought in its complaint; typically a judgment for possession and/or damages.

One note to both parties in an unlawful detainer action (well, in any action): Bring evidence to support your claim. For some reason parties to eviction actions seem to believe the other side won’t show, or if they do, they won’t be prepared, and the judge will automatically grant them judgment. Avoid this mindset. Bring evidence the tenant didn’t pay rent (was there correspondence concerning missed payments?). Bring proof of damaged property (are there pictures of the unhinged front door?). Bring the lease, the termination notice, complaints from other tenants. Bring everything.

Following consideration of the evidence, if the landlord prevails it will be awarded a judgment for possession of the property, unpaid rent, and other expenses provided for under the lease.

Step 5: Eviction by Sheriff and Removal of Tenant Property

Once a judgment has been obtained, the landlord provides a copy of it along with a fee to the appointed local law enforcement officer (usually a sheriff). The sheriff posts notice of the date the eviction will occur (as always, this posting must be done in compliance with state law), and if the tenant has not vacated the property before then, the sheriff will remove them. Because law enforcement officers don’t get paid to move couches, typically the landlord will have to provide labor to remove the tenant’s personal property.

While it should be clear from everything we’ve discussed to this point, if the law says that only the sheriff can evict, then the landlord cannot remove the tenant itself, judgment or not. Usually this is express under state law. For example, in New Jersey, the only way a landlord can evict a tenant is if a special court officer with a legal court order, a warrant for removal, comes out himself and does the eviction. Additionally, as noted earlier, self-help actions can be dangerous. Given that evictions can become emotionally charged events, it is in all parties’ best interests to leave this last step to the trained law-enforcement professionals.

Once the tenant’s personal property has been removed, state law will dictate how the landlord must handle it. Some states require the landlord to make a good-faith effort to contact the tenant regarding the property (e.g., mail notice to tenant’s last known address). Others provide the landlord can dispose of the property if the tenant has abandoned the property. Although what constitutes “abandoned” varies by state (many agree that if tenant has not responded to a notice within 30 days, the property is considered abandoned), a general test is whether the tenant clearly has no intent to return to the premises for their property.

Other states don’t require any notice at all. For example, in Georgia if a landlord obtains judgment it is issued a “writ of possession.” The writ is effective seven days after issuance, and after this seven-day period the landlord can dispose of any tenant property left on the premises. He need not notify the tenant. He need not store the property. Seven days in Georgia. Period.

Other states can get a little more complicated, for example, requiring a landlord not only to store property and notify the tenant of the same, but then to dispose or auction off property through public sale (after public notice is made) depending on the value of the property.

Differences Between Commercial and Residential Evictions

Generally state laws provide less protection to tenants in a commercial setting than in a residential one. Not only are people’s homes not in play in a commercial lease, but the courts expect that two commercial parties are less likely to be in a position of unequal bargaining power. They can look out for themselves.

Because of this, some states allow a commercial lease to modify eviction procedures. For example, a lease may include a waiver of the right to a jury. Or, where a cure period under state law is three days, the commercial lease may give a tenant five business days to cure.

Some other common differences include:

• Filing fees: Court fees may be higher for commercial evictions.
• Sheriff bond: Residential evictions generally only require a fee to be paid to the sheriff for the eviction, but commercial evictions may required a landlord to also post a sheriff bond.
• Self-help: Some states allow self-help in the commercial realm. For example, in Arizona a landlord can lock out a tenant without going to court first. The tenant then has to bring suit if it believes it should regain possession.
• Landlord duty to maintain property: A landlord generally has the obligation to maintain a residential property in safe and habitable condition. Where it fails to do so, a tenant may have the right to withhold rent until the landlord complies. No similar obligation exists in commercial tenancies. A landlord must only provide what he agreed to under the lease. Further, even if the landlord fails to maintain the property as he said he would, the lease can still provide that the tenant may be evicted if it doesn’t continue to pay rent.
• Where eviction action is filed: Residential actions may be filed in different courts than commercial evictions. For example, in Massachusetts residential actions can be filed in the local housing court, the Boston Municipal Court, appropriate district court, or in certain circumstances in Superior Court. But commercial evictions don’t have access to the housing court.

Conclusion

While the intricacies vary state by state, evictions follow a similar path no matter where the property is: (1) notice of termination of tenancy, (2) file a complaint and serve tenant with summons and complaint, (3) tenant files answer with defenses, if any, (4) trial and judgment, and (5) notice and eviction by sheriff.

Of course, given that the courts, especially in residential evictions, require strict compliance with the intricacies, that failure to comply can add months, dollars and headaches to an eviction action, and that this discussion is only for informational purposes (and not legal advice), if you have any specific eviction issues, please contact a licensed real estate attorney!

 

 

Source: How to Navigate the Real Estate Eviction Process

https://www.creconsult.net/market-trends/how-to-navigate-the-real-estate-eviction-process/

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How to Calculate The Debt Yield Ratio

The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now, the debt yield is used by some lenders as an additional underwriting ratio. However, since it’s not widely used by all lenders, it’s often misunderstood. In this article, we’ll discuss the debt yield in detail, and we’ll also walk through some relevant examples.

What is The Debt Yield?

First, what exactly is the debt yield? Debt yield is defined as a property’s net operating income divided by the total loan amount.

For example, if a property’s net operating income is $100,000 and the total loan amount is $1,000,000, then the debt yield would simply be $100,000 / $1,000,000, or 10%.

The debt yield equation can also be re-arranged to solve for the Loan Amount:

For example, if a lender’s required debt yield is 10% and a property’s net operating income is $100,000, then the total loan amount using this approach would be $1,000,000.

What The Debt Yield Means

The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low-interest rates, or high amortization periods. The debt yield is also used as a common metric to compare risk relative to other loans.

What’s a good debt yield? As always, this will depend on the property type, current economic conditions, strength of the tenants, strength of the guarantors, etc. However, according to the Comptroller’s Handbook for Commercial Real Estate, a recommended minimum acceptable debt yield is 10%.

Debt Yield vs Loan to Value Ratio

The debt service coverage ratio and the loan to value ratio are the traditional methods used in commercial real estate loan underwriting. However, the problem with using only these two ratios is that they are subject to manipulation. The debt yield, on the other hand, is a static measure that will not vary based on changing market valuations, interest rates and amortization periods.

The loan to value ratio is the total loan amount divided by the appraised value of the property. In this formula, the total loan amount is not subject to variation, but the estimated market value is. This became apparent during the 2008 financial crises, when valuations rapidly declined and distressed properties became difficult to value. Since market value is volatile and only an estimate, the loan to value ratio does not always provide an accurate measure of risk for a lender.

As you can see, the LTV ratio changes as the estimated market value changes (based on direct capitalization). While an appraisal may indicate a single probable market value, the reality is that the probable market value falls within a range and is also volatile over time. The above range indicates a market cap rate between 4.50% and 5.50%, which produces loan to value ratios between 71% and 86%. With such potential variation, it’s hard to get a static measure of risk for this loan. The debt yield can provide us with this static measure, regardless of what the market value is. For the loan above, it’s simply $95,000 / $1,500,000, or 6.33%.

Debt Yield vs Debt Service Coverage Ratio

The debt service coverage ratio is the net operating income divided by annual debt service. While it may appear that the total debt service is a static input into this formula, the DSCR can in fact also be manipulated. This can be done by simply lowering the interest rate used in the loan calculation or by changing the amortization period for the proposed loan. For example, if a requested loan amount doesn’t achieve a required 1.25x DSCR at a 20-year amortization, then a 25-year amortization could be used to increase the DSCR. This also increases the risk of the loan, but is not reflected in the DSCR or LTV.

As you can see, the amortization period greatly affects whether the DSCR requirement can be achieved. Suppose that in order for our loan to be approved, it must achieve a 1.25x DSCR or higher. As demonstrated by the chart above, this can be accomplished with a 25-year amortization period, but going down to a 20-year amortization breaks the DSCR requirement.

Assuming we go with the 25-year amortization and approve the loan, is this a good bet? Since the debt yield isn’t impacted by the amortization period, it can provide us with an objective measure of risk for this loan with a single metric. In this case, the debt yield is simply $90,000 / $1,000,000, or 9.00%. If our internal policy required a minimum 10% debt yield, then this loan would not likely be approved, even though we could achieve the required DSCR by changing the amortization period.

Just like the amortization period, the interest rate can also significantly change the debt service coverage ratio.

As shown above, the DSCR at a 7% interest rate is only 1.05x. Assuming the lender was not willing to negotiate on amortization but was willing to negotiate on the interest rate, then the DSCR requirement could be improved by simply lowering the interest rate. At a 5% interest rate, the DSCR dramatically improves to 1.24x.

This also works in reverse. In a low-interest rate environment, abnormally low rates present future refinance risk if the rates return to a more normalized level at the end of the loan term. For example, suppose a short-term loan was originally approved at 5%, but at the end of a 3-year term rates were now up to 7%. As you can see, this could present significant challenges when it comes to refinancing the debt. The debt yield can provide a static measure of risk that is independent of the interest rate. As shown above, it is still 9% for this loan.

Market valuation, amortization period, and interest rates are in part driven by market conditions. So, what happens when the market inflates values and banks begin competing on loan terms such as interest rate and amortization period? The loan request can still make it through underwriting, but will become much riskier if the market reverses course. The debt yield is a measure that doesn’t rely on any of these variables and therefore can provide a standardized measure of risk.

Using Debt Yield To Measure Relative Risk

Suppose we have two different loan requests, and both require a 1.20x DSCR and an 80% LTV. How do we know which one is riskier?

As you can see, both loans have identical structures with a 1.20x DSCR and an 80% LTV ratio, except the first loan has a lower cap rate and a lower interest rate. With all of the above variables, it can be hard to quickly compare the risk between these two loans. However, by using the debt yield, we can quickly get an objective measure of risk by only looking at NOI and the loan amount:

As you can see, the first loan has a lower debt yield and is therefore riskier according to this measure. Intuitively, this makes sense because both loans have the same NOI, except the total loan amount for Loan 1 is $320,000 higher than Loan 2. In other words, for every dollar of loan proceeds, Loan 1 has just 7.6 cents of cash flow versus Loan 2 which has 10.04 cents of cash flow.

This means that there is a larger margin of safety with Loan 2, since it has higher cash flow for the same loan amount. Of course, underwriting and structuring a loan is much deeper than just a single ratio. There are other factors that the debt yield can’t consider such as guarantor strength, supply and demand conditions, property condition, strength of tenants, etc. However, the debt yield is a useful ratio to understand, and it’s being utilized by lenders more frequently since the financial crash in 2008.

Conclusion

The debt service coverage ratio and the loan to value ratio have traditionally been used (and will continue to be used) to underwrite commercial real estate loans. However, the debt yield can provide an additional measure of credit risk that isn’t dependent on the market value, amortization period, or interest rate. These three factors are critical inputs into the DSCR and LTV ratios, but are subject to manipulation and volatility. The debt yield on the other hand uses net operating income and total loan amount, which provides a static measure of credit risk, regardless of the market value, amortization period, or interest rate. In this article, we looked at the debt yield calculation, discussed how it compares to the DSCR and the LTV ratios, and finally looked at an example of how the debt yield can provide a relative measure of risk.

 

Source: How to Calculate The Debt Yield Ratio

https://www.creconsult.net/market-trends/how-to-calculate-the-debt-yield-ratio/

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Debt Service Coverage Ratio (DSCR): A Calculation Guide

The Debt Service Coverage Ratio, often abbreviated as “DSCR”, is an important concept in real estate finance and commercial lending. It’s critical when underwriting commercial real estate and business loans as well as tenant financials, and it is a key part in determining the maximum loan amount. In this article, we’ll take a deep dive into the debt service coverage ratio, explain what a DSCR loan is, and walk through several examples along the way.

What Is The Debt Service Coverage Ratio (DSCR)?

The debt service coverage ratio (DSCR) measures the ability of a borrower to repay its debt. The DSCR is widely used in commercial loan underwriting and is a key formula lenders use to determine the size of a loan.

Debt Service Coverage Ratio (DSCR) Formula

The debt service coverage ratio formula depends on whether a loan is for real estate or a business. While the logic behind the DSCR formula is the same for both, there is a difference in how it is calculated.

DSCR Formula for Real Estate

For commercial real estate, the debt service coverage ratio (DSCR) definition is net operating income divided by total debt service:

For example, suppose Net Operating Income (NOI) is $120,000 per year and total debt service is $100,000 per year. In this case, the debt service coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals 1.20. It’s also common to see an “x” after the ratio. In this example, it could be shown as “1.20x”, which indicates that NOI covers debt service 1.2 times.

DSCR Formula for a Business

For a business, the debt service coverage ratio definition is EBITDA divided by total debt service:

EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. For example, if EBITDA for a company was 240,000 for the last fiscal year, and total debt service was 141,000, then the DSCR would be 1.7x.

Sometimes there will be variation in how the debt service coverage ratio is calculated. For example, capital expenditures are commonly excluded from the DSCR calculation because capex is not considered an ongoing operational expense, but rather a one-time investment. Lenders will have credit policies that define how the debt service ratio is calculated, but there is often still some variation depending on the situation. It’s important to clarify how the DSCR is calculated with all parties involved.

Debt Service Coverage Ratio (DSCR) Meaning

What does the debt service coverage ratio mean? A DSCR greater than or equal to 1.0 means there is sufficient cash flow to cover debt service. A DSCR below 1.0 indicates there is not enough cash flow to cover debt service. However, just because a DSCR of 1.0 is sufficient to cover debt service does not mean it’s all that’s required.

Typically, a lender will require a debt service coverage ratio higher than 1.0x to provide a cushion in case something goes wrong. For example, if a 1.20x debt service coverage ratio was required, then this would create enough of a cushion so that NOI could decline by 16.7%, and it would still be able to fully cover all debt service obligations.

What is a Good Debt Service Coverage Ratio?

What is the minimum or appropriate debt service coverage ratio? Unfortunately, there is no one size fits all answer and the required DSCR will vary by bank, loan type, and by property type.

However, typical DSCR requirements usually range from 1.20x-1.40x. In general, stronger, stabilized properties will fall on the lower end of this range, while riskier properties with shorter term leases or less creditworthy tenants will fall on the higher end of this range.

How to Calculate DSCR for a Real Estate Loan

The DSCR is critical when sizing a commercial real estate loan. Let’s take a look at how the debt service coverage ratio is calculated for a commercial property. Suppose we have the following Proforma:

As you can see, our first year’s NOI is $778,200 and total debt service is $633,558. This results in a year 1 debt service coverage ratio of 1.23x ($778,200/$633,558). And this is what the debt service coverage ratio calculation looks like for all years in the holding period:

As shown above, the DSCR is 1.23x in year 1 and then steadily improves over the holding period to 1.28x in year 5. This is a simple calculation, and it quickly provides insight into how loan payments compare to cash flow for a property. However, sometimes this calculation can get more complex, especially when a lender makes adjustments to NOI, which is a common practice.

Adjustments to NOI When Calculating DSCR

The above example was fairly straightforward. But what happens if there are significant lender adjustments to Net Operating Income? For example, what if the lender decides to include reserves for replacement in the NOI calculation as well as a provision for a management fee? Since the lender is concerned with the ability of cash flow to cover debt service, these are two common adjustments banks will make to NOI.

Reserves are essentially savings for future capital expenditures. These capital expenditures are major repairs or replacements required to maintain the property over the long-term and will impact the ability of a borrower to service debt. Similarly, in the event of foreclosure, a professional management team will need to be paid out of the project’s NOI to continue operating the property. While an owner managed property might provide some savings to the owner, the lender will likely not consider these savings in the DSCR calculation.

Other expenses a lender will typically deduct from the NOI calculation include tenant improvement and leasing commissions, which are required to attract tenants and achieve full or market-based occupancy.

Consider the following proforma, which is the original proforma we started with above, except with an adjusted NOI to account for all relevant expenses that could impact the property’s ability to service debt:

As illustrated by the proforma above, we included reserves for replacement in the NOI calculation, as well as a management fee. This reduced our year 1 NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR? Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This is much lower than what we calculated above and could reduce the maximum supportable loan amount or potentially kill the loan altogether. Here’s what the new DSCR looks like for all years in the holding period:

Now when the debt service coverage ratio is calculated it shows a much different picture. As you can see, it’s important to take all the property’s required expenses into account when calculating the DSCR, and this is also how banks will likely underwrite a commercial real estate loan.

How to Calculate DSCR for a Business Loan

The debt service coverage ratio is also helpful when analyzing business financial statements. This could be helpful when analyzing tenant financials, when securing a business loan, or when seeking financing for owner occupied commercial real estate.

How does the DSCR work for a business? The general concept of taking cash flow and dividing by debt service is the same. However, instead of looking at NOI for a commercial property, we need to substitute in some other measure of cash flow from the business available to pay debt obligations. But which definition of cash flow should be used? Given the importance of debt service coverage, there is surprisingly no universal definition used among banks, and sometimes there is even disagreement within the same bank. This is why it’s important to clarify how cash flow will be calculated.

With that said, typically Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) or some form of adjusted EBITDA will be used. Common adjustments include adding back an appropriate capital expenditure amount required to replace fixed assets (which would offset the depreciation add back), and also considering working capital changes (to cover investments in receivables and inventory).

Let’s take an example of how to calculate the debt service coverage ratio for a business.

As shown above, EBITDA (cash flow) is $825,000 and total debt service is $800,000, which results in a debt service coverage ratio of 1.03x. This is found by dividing EBITDA of $825,000 by total debt service of $800,000. This gives us an indication of the company’s ability to pay its debt obligations.

If this analysis were for a tenant, we might want to subtract out existing lease payments and add in the new proposed lease payments. Or, if this were for an owner occupied commercial real estate loan, we would probably subtract out the existing lease payments and add in the proposed debt service on the new owner occupied real estate loan.

Based on the above 1.03x DSCR, it appears that this company can barely cover its debt service obligations with current cash flow. There could be other ways of calculating cash flow or other items to consider, but strictly based on the above analysis, it’s not likely this loan would be approved. However, sometimes looking at just the business alone doesn’t tell the whole story about cash flow and debt service coverage.

Global Debt Service Coverage Ratio (Global DSCR)

Calculating the debt service coverage ratio like we did above doesn’t always tell the whole story. For example, this could be the case when the owner of a small business takes most of the profit out with an above market salary. In this case, looking at both the business and the owner together will paint a more accurate picture of cash flow and also the debt service coverage ratio. Suppose this was the case with the company above. This is what a global cash flow analysis might look like if the owner was taking most of the business income as salary:

In the above analysis, we included the business owner’s personal income and personal debt service. Assuming the owner was taking an abnormally high salary from the business, this would explain the low debt service coverage ratio when looking at the business alone, as in the previous example. In this new global debt service coverage calculation, we take this salary into account as cash flow, as well as all personal debt service and living expenses. Digging into how personal cash flow is calculated is beyond the scope of this article, but most of this information can be found just from personal tax returns, the personal financial statement, and the credit report, all of which will be required by a lender when underwriting a loan.

As you can see, this new global DSCR paints a much different picture. Now global income is $1,575,000 and global debt service is $1,100,000, which results in a global DSCR of 1.43x. This is found by simply dividing global income by global debt service ($1,575,000/$1,100,000). More often than not, a global cash flow analysis like this tells the full story for many small businesses.

DSCR Cheat Sheet

Fill out the quick form below and we’ll email you our free debt service coverage ratio Excel cheat sheet containing helpful calculations from this article.

Conclusion

In this article, we discussed the debt service coverage ratio, often abbreviated as just DSCR. The debt service coverage ratio is a critical concept to understand when it comes to underwriting commercial real estate and business loans, analyzing tenant financials, and when seeking financing for owner occupied commercial real estate. We covered the definition of the debt service coverage ratio, what it means, and we also covered several commercial real estate and business examples for calculating the debt service coverage ratio. While the DSCR is a simple calculation, it’s often misunderstood, and it can be adjusted or modified in various ways. This article walked through the debt service coverage ratio step by step to clarify these calculations.

 

Source: Debt Service Coverage Ratio (DSCR): A Calculation Guide

https://www.creconsult.net/market-trends/debt-service-coverage-ratio-dscr-a-calculation-guide/

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