Loan underwriting goes back to the future with resurgence of DSCR analysis 

Two metrics are better than one, with market participants telling us DSCR is being commonly used alongside debt yield in evaluating lending opportunities.   

More lenders and borrowers are bringing back debt service coverage ratios as a key metric in evaluating the risk profile of a loan, adding DSCR to debt yield as important factors to consider when evaluating new debt opportunities. 

“Coming out of the Global Financial Crisis, the biggest change among lenders was probably moving from debt service coverage ratios to debt yields as the primary risk measure for commercial mortgages,” said Will Pattison, head of research and strategy at New York-based manager MetLife Investment Management. “Today, we are seeing somewhat of a reversal, in that debt service coverage is becoming equally important to debt yield.” 

Two is better than one 

Calculating a property’s debt service coverage ratio involves dividing a property’s net operating income by its debt service, with the aim of evaluating a sponsor’s ability to repay debt. In contrast, debt yield – calculated by dividing a property’s NOI by the total amount of a loan – helps a lender to determine the risk involved with a loan that is being written. 

“Prior to the GFC, a lender might have wanted a 1.5 or higher DSCR. But as rates declined, most loans had DSCRs of at least 2.0 or higher, which make the metric more difficult to use. DSCR looked too positive, or too strong, for many lenders and they felt as if they needed another risk measure that would help them differentiate between high- and low-risk loans,” Pattison said. “As rates are once again on the upswing, DSCR is now a more useful measure or indicator of risk – or at least is being perceived that way.” 

Evaluating the usefulness of metrics is important in today’s market, with Pattison noting that for MetLife, cap rates have become a less useful metric than in the past. This is particularly true for assets in the industrial and apartment sectors, where rents have moved up by 20 percent to 30 percent in the last year or so.  

“In some markets we know, necessarily, that year one income is lower than the year two income will be, so therefore the cap rate has less value. So instead of that, we have been focusing more on discount rates and also underwriting downside scenarios,” Pattison added. 

The topic was also part of a recent Real Estate Capital USA Roundtable, when Michael Cale, co-head of US debt investments at Allianz Real Estate, pointed out a lot of deals are not viable today because of where rates are and where loan spreads are. 

“Debt yield is one thing, coverage is another. With cap rates where they were and interest rates going up, what might have been a 65 percent loan request six to nine months ago just doesn’t work anymore based on the economics. You have to push back and require somebody to put more equity in — and that’s a situation that makes people uncomfortable, based on what’s happened in the past,” Cale added.