By Venture Mortgage Corporation
Lenders use DSCR as a first-look; commercial real estate investors would be wise to do the same.
The Federal Reserve has opted not to raise rates in September 2015, but experts speculate that the rate hike has only been delayed for a short time. When rates do eventually rise, it will allow institutional investors and funds to deploy their assets in other locations – namely bonds – and will hopefully stop the chase after yield by purchasing real estate at 4%, 3%, or even 2% cap rates. This will be a good thing for the stability of the commercial real estate world: while it does correlate with rising interest rates for investors and the debt placed on properties, this should level out the “crazy” deals being done, or at a minimum, keep deals in check.
It is vitally important to “stress test” any purchase or refinance you are currently pursuing by:
1) Finding the 1:1 DSCR in terms of value and rents received.
2) Considering changing cap rates: if a property is purchased at a 6% cap rate, evaluate what it looks like at a 9% or 10% (closer to historical averages) cap rate.
3) Evaluating changes in market rents: if rents fall 5%, 10%, or 20%, what will happen to the ability to cover the debt service?
If very small moves in the market cause the property to be classified as underwater, it is probably a good sign to turn and run, or, at a minimum, start getting financial reserves in order to cover a potential shortfall.
To avoid this type of rate risk, lock in rates for the long haul. There are a variety of lenders offering 10 year, 15 year, 20 year, and even 25 year fixed rates on commercial real estate properties. A trusted and experienced Venture Mortgage Banker will be able to quickly assess your portfolio and help you to explore lending options to lock in rates for a long fixed-period. This will allow you to take risk off the table for the near and not-so-near future, as well as capitalizing on the historically low rates and high valuations we are seeing in the market today.
There are numerous other metrics, ratios, and tests used to determine the strength of a real estate investment. However, if you are an investor who uses debt as a tool to gain wealth, it is important to understand this basic stress test associated with the Debt Service Coverage Ratio, as well as being aware of the challenges associated with rising interest rates and plateauing values.