Debt Service Coverage (DSCR) in DSTs: What a Safe Number Looks Like

DSCR is NOI over debt service, but lenders compute it on their own definitions and usually as if the loan amortized

The OCC's commercial real estate lending handbook defines the debt service coverage ratio as NOI divided by annual debt service requirements, a measure of the borrower's ability to service its debt. It adds that coverage calculations for loan covenants may differ from the ratio used in underwriting, so the definitions in the loan documents control.

A filed DST loan agreement shows how strict those definitions can be. Its net cash flow is gross income less operating expenses less the full amount underwritten for the replacement reserve, whether or not deposits are being made. Its coverage ratio divides that by the debt service that would be due assuming a payment based on the interest rate and a 30-year amortization, even though the loan's monthly payment is interest only. When a memorandum quotes coverage, ask which numerator and which payment it uses.

1.25x is a lender's floor, not an investor's comfort level

Freddie Mac's conventional fixed-rate term sheet sets a minimum amortizing coverage of 1.25x for multifamily loans of every term, with maximum loan-to-value of 75 to 80 percent for amortizing and partial interest-only loans and 65 to 70 percent for full-term interest-only loans. It waives its refinance test only when amortizing coverage is 1.40x or more and loan-to-value 60 percent or less. Its footnote says coverage for interest-only periods is calculated with an amortizing payment.

The filed DST loan uses the same floor in a different place: insurance proceeds after a casualty are released for restoration only if the restored property will support coverage no lower than before the loss and in no event below 1.25 to 1.0, again on a 30-year amortizing basis. A lender sizing to 1.25x is protecting its loan, not your distribution.

The OCC says the right ratio depends on how volatile the cash flow is: a lower ratio may be appropriate for properties with long-term net leases to highly creditworthy tenants, and properties with volatile cash flows, such as hotels, may warrant a higher one. Judge the coverage against the asset; see hotel DSTs and tenant credit analysis.

Interest-only periods inflate coverage, so recompute it for the year amortization starts

The OCC handbook warns that interest-only terms can lower the chance of payment default by providing higher coverage, but increase the loss if default happens and the risk of repaying the balance at maturity. It says the property should meet coverage requirements as though the loan were amortizing, and gives an example in which a $1 million, five-year loan amortizing over 25 years at 6 percent would have a balance of $899,000 at maturity, so an interest-only lender could size the loan at $899,000 to compensate.

Hypothetical: a DST has NOI of $1.2 million and a $10 million loan at 5.0 percent. Interest-only debt service is $500,000, so coverage is 2.40x. Amortizing over 30 years, debt service is about $644,000 and coverage is about 1.86x. If NOI falls 20 percent to $960,000, amortizing coverage is about 1.49x. Run your own numbers with your CPA. The effect on your income is at cap rate vs cash yield in a DST.

Stress the coverage yourself: lower rent, higher expenses and, on floating debt, a higher rate

A quick test of cushion is 1 minus 1 divided by the DSCR. At 1.25x, NOI can fall 20 percent before it only covers debt service; at 1.50x, about 33 percent; at 2.00x, 50 percent. Below that point the trust cannot pay its lender from operations, and long before it the trust stops paying you, because distributions come from cash left after debt service and reserves.

The OCC expects lenders to stress-test cap rates, interest rates and coverage to see whether a property stays viable in a downturn. Ask the sponsor for the coverage in each projected year, on an amortizing basis, under its base case and a downside case. On floating-rate debt, recompute coverage at the rate cap's strike; one sponsor's 10-K describes a five-year interest-only DST loan at one-month SOFR plus 2.5 percent swapped to a fixed 5 percent. The mechanics are at floating-rate debt and rate caps in DSTs.

When coverage slips, a DST has fewer tools than an ordinary owner, and distributions absorb the shortfall first

Rev. Rul. 2004-86 bars the trustee from renegotiating or refinancing the acquisition debt except on the tenant's bankruptcy or insolvency, so the trust cannot extend, restructure or recapitalize its way through a weak year. The filed loan agreement's backstop is a debt service reserve funded at closing, about $714,000 in that deal, which the lender draws when rent falls short and which must be topped back up to three monthly payments; the reserve is released only after net cash flow reaches a set level for two consecutive quarters.

If the shortfall persists, the documents shift control: on an event of default that loan opens a cash management period in which the lender may apply property cash to the debt. The sponsor's remaining tool is converting the trust to an LLC that can refinance, at the cost of its grantor-trust status. The lender-document side is at DST lender documents and carve-outs and the wider rate risk at DST leverage and interest-rate risk.