Private lenders offer DSCR (debt service coverage ratio) loans to investors with the “buy-and-hold” strategy for long-term permanent money at stabilization. The DSCR loan program is an alternative for investors to compare against the long-term loan programs offered by traditional lenders.
This article will give an overview of the nine elements that affect a private lender’s underwriting of a DSCR loan. Amplend understands that residential real estate investors need to understand how private lenders evaluate the merits of a deal and the factors to achieve competitive terms.
Key Takeaways
- The credit score is the only underwriting element specific to the investor.
- A DSCR loan is long-term permanent money offered by private lenders as an alternative to the programs offered by traditional banks.
- The debt coverage ratio is the most important element a private lender considers when underwriting a DSCR loan.
- A lender will lend higher into the capital stack and offer a higher LTV when the DSCR ratio exceeds its target.
- The objectives of a DSCR loan is to shorten the time to service a high-interest, short-term loan and to realize cash from the built-in equity sooner.
Defined Terms
Above-the-line expenses – the operating expenses applied against the rent income to calculate NOI.
Below-the-line expenses – the non-operating expenses applied against the NOI to calculate cash flow, like debt service and funding reserve accounts.
Capital Stack – the components of the loan amount and the investor’s equity to total the property’s market value.
The Decisive Elements
There are nine critical elements private lenders use to determine the rate and terms of a DSCR loan. These elements are the:
- Debt service coverage ratio,
- Leverage,
- Credit score,
- Origination fee,
- Prepayment penalty,
- Interest rate type,
- Property type,
- Loan size, and
- Loan type.
DSCR Loan Objectives
The underwriting of a long-term DSCR loan for stabilized properties is more diligent than underwriting for a short-term acquisition and renovation loan. However, a private lender keeps its entrepreneurial spirit in this process, and the time between the application and funding remains shorter than that of a traditional lender.
The objectives of a DSCR loan are to shorten the time the investor services the higher-interest, short-term loan and to realize sooner the benefits of the equity created by the renovations.
With these in mind, let’s review each of the above elements.
Debt Service Coverage Ratio
This is the most important ratio a private lender considers when underwriting a stabilized property. The formula for this ratio is:
NOI (net operating income ÷ ADS (annual debt service)
For illustration, if the ADS (principal and interest only) is $24,000, or $2,000 per month, and the property’s NOI is $30,000, or $2,500 per month, then:
$30,000 ÷ $24,000 = 1.25
The translation of this ratio is the availability of $1.25 of net income (rent less expenses) for every $1.00 of debt service.
However, when an investor makes this calculation for its own due diligence, attention must be given to the loan payments that contain the funding of an escrow account for property taxes and insurance.
Remember, mortgage payments of principal and interest are not within the definition of operating expenses, but property taxes and insurance are expensed above the line. Care must be given to make sure these expenses are not counted twice—once above the line as expenses and again below the line as part of the debt service.
The 1.25 coverage ratio calculated above is above the industry-standard target ratio of 1.15. A private lender will extend competitive loan terms for properties performing above its target ratio. The higher the ratio, the less perceived risk.
Leverage
The debt service coverage ratio is important when a private lender considers leverage. When a lender perceives less risk, then there is a willingness to lend higher into the capital stack.
Leverage is a percentage of the loan amount against the property’s market value. This percentage is also known as the loan-to-value (LTV) ratio. An investor will receive less cash out on a loan with a 60% LTV than on a loan with a 70% LTV. The higher the LTV, the more cash a lender is willing to finance because of the lower risk perception. Risk is related to the debt coverage ratio and leverage.
The formula to calculate leverage is:
Loan Amount ÷ Market Value
For example, if a property’s market value is $200,000, and a lender is willing to lend up to 70%, then:
$200,000 x .7 = $140,000, then
$140,000 ÷ $200,000 = .7, or 70%.
The term “capital stack” in this example is the sum of the loan amount and the investor’s equity is the “stack” that comprises the total market value. To illustrate:
| $140,000 | Loan Amount |
| + 60,000 | Investor Equity |
| $200,000 | Market Value |
So, the higher the LTV ratio, the farther into the capital stack a lender is willing to invest. This translates to more cash out to the investor because of the lower perception of risk.
With a DSCR loan secured by a stabilized property, the underwriting ratios are based on market value, unlike short-term loans where the ratios are based on cost. There is built-in equity when the value of the improvements exceeds the costs.
Credit Score
The investor’s credit score will carry more weight in underwriting a DSCR loan than with a short-term acquisition loan. A credit score is verifiable and a quick way for a lender to measure risk. The credit score is the only element out of the nine that directly and exclusively relates to the investor.
The other eight elements focus on the property’s performance and the lender’s tolerance for risk.
A credit score directly affects the interest rate and the leverage.
The best way for an investor to achieve a competitive rate and a higher LTC is to improve their credit score. Improving a credit score is two-fold: making prompt payments on all obligations and monitoring the credit report for errors.
Origination Fees
An origination fee is expressed as a percentage of the loan amount charged to cover the lender’s direct costs to process the application, underwrite the deal, and administer the loan. Typically, the origination fee charged on a DSCR loan with an acceptable coverage ratio will be between 0.5%-1% of the loan amount.
Origination fees are also known as discount fees or points.
Rule of thumb: a reputable private lender will collect an origination fee at closing and will not require any payment prior to processing or underwriting.
The origination fee on a long-term DSCR loan will be lower than that charged on a short-term acquisition loan collateralized by vacant, distressed property.
Can an origination fee be negotiable? Perhaps, but any reduction will result in a higher interest rate.
It is important to know that origination fees are a part of the annual percentage rate (APR) to reflect the total cost of capital. The origination fee and others associated with the loan are added to the interest rate. The interest rate is only reflective of the cost of borrowing the principal.
Prepayment Penalty
Lenders charge a prepayment penalty to stabilize their return. Lenders are investors, and investments are made with a pre-determined number of payments. Loan payments are the return of and on the invested capital to fund operations and increase the available cash to invest in other opportunities.
Profits and available cash are reduced if a loan is paid too early in the term. The prepayment penalty stabilizes the loan and guarantees the profit.
Generally, this penalty is in effect during the first 5-8 years of the term, and the penalty can range from 1%-5% of the outstanding balance. Therefore, the penalty reduces the lender’s risk, and having this penalty in place will improve the loan’s pricing with a lower interest rate and a higher LTV.
This back-end charge can aid the investor in calculating their investment return. When an investor knows the total satisfaction amount at a refinance or a sale, then the return is accurate. If an investor plans to hold the property longer than the penalty’s effective period, then the return is higher, and the penalty is a non-issue.
A prepayment penalty is a good “give” for a lower interest rate and a higher LTV without the penalty affecting the exit strategy.
Interest Rate Type
One benefit of a long-term DSCR loan on stabilized property is the choices that may be available on the interest rate structure. While the offered rate remains a function of risk, the structure of the rate can be varied. The common structure choices offered by private lenders on residential rental properties are:
- 5/6 ARM (adjustable-rate mortgage),
- 7/6 ARM,
- 30-year fixed, and
- interest only.
As each rate type is reviewed below, please keep in mind that the quoted rate remains the result of the lender’s underwriting and its measurement of risk. While this rate may not be subject to negotiation, the choice of the rate type can be at the investor’s discretion relative to the hold period and the market conditions.
5/6 ARM
The two indices used by lenders to set the beginning rate for an ARM are the US prime rate and the constant maturity treasury rate. The prime rate is set by commercial banks and offered to its most creditworthy customers. The Federal Reserve Board sets the constant maturity treasury rate, and it represents the one-year yield on its auctioned securities. The rate set by the Federal Reserve Board is phasing out the use of LIBOR.
The reference “5/6” means the interest rate quoted by the lender will remain fixed for the first five years of the loan term. Then, the rate will adjust every six months until the loan matures or is satisfied. There may be an opportunity to negotiate a cap on the interest rate at times of adjustment.
A 5/6 ARM could benefit an investor if the anticipated hold period is less than the time of the fixed low-rate period. A key to this consideration is the prepayment penalty during the first five years when the fixed low rate is in effect.
7/6 ARM
The concepts behind a 7/6 ARM are the same as the 5/6 ARM, but with a fixed interest rate in place for the first seven years of the term. Adjustments will be made every six months thereafter until the loan matures or is satisfied. The fixed interest rate on a 7/6 ARM is usually lower than the 5/6 ARM, and there may be room to negotiate the prepayment penalty.
An investor should make every attempt to negotiate a cap on the adjustments and must consider the hold period for the property.
The key would be for the prepayment penalty to not exceed the interest savings realized during the first seven-year period when the rate may be at its lowest point.
30-Year Fixed
This rate type is the common structure for owner-occupied properties.
On any fixed-rate loan, the interest rate remains fixed for the entire loan term. The rate will not adjust at any time throughout the loan. The loan is amortized over a 30-year period, but the loan term could be 15 or 20 years. This structure is known as a balloon mortgage where the last payment will be significantly higher because the loan matures before it self-amortizes to a $0 balance.
If there are no prepayment penalties in place for a 30-year fixed rate mortgage, then there will be an upward adjustment on the quoted rate.
Interest Only
An interest-only loan is exactly as defined. The loan payments only service the interest, and the principal balance remains unchanged.
The rates on interest-only loans tend to be higher than amortizing loans and the LTV ratios are lower. A lender perceives these loans as riskier and will not lend too high into the stack.
An investor seeking an interest-only loan on long-term, permanent money is truly betting on a strong market at the end of its hold period. If the market stays strong, then an interest-only loan could be a good strategy as the principal remains low relative to the market appreciation.
The strategy is to sell the property before the market turns and the values decrease.
Property Type
Private lenders targeting residential investors with the model to create value consider a property with a detached single-family structure as the least risky. These private lenders only have the risk tolerance for Grade A properties in primary Tier 1 markets. These lenders do not lend on value-add opportunities.
However, private lenders who target the value-add investor will underwrite a “B” or a “C” property in second-tier locations with value potential. These lenders underwrite to an after-repair value (ARV).
A lender will offer the best rates to investors for single-family properties. These properties are easier to manage and have a shorter time on the market before a sale. Lenders prefer one tenant with one set of problems.
Residential property is defined as a single household with 1-4 units. While multi-unit properties may look better to an investor’s proforma in terms of cash flow, lenders will underwrite to an increased risk, and the risk will be reflected in the interest rate and the LTV.
Loan Size
The size of a loan and its effect on the quoted rate is subjective. As a general statement, a lender will increase its quoted rate between 25-100 bps if the loan amount is too small or too large.
The “sweet spot” for private lenders bullish on value-add opportunities is loan sizes between $200,000-$1.49 million. This range is usually not subjected to any adjustments to the underwritten quote.
While a “small” loan may be less risky to a lender in terms of capital outlay, lenders have fixed costs for processing, underwriting, and administering a loan. A $50,000 loan will have the same costs as a $5 million loan. The increase in the APR will seem disproportionate when these fixed amounts are charged to small loans.
As a general statement, large loans are riskier to private lenders targeting value-add residential investors.
Loan Type
This element is predicated on the other corresponding elements of leverage, interest rate type, property type, and loan size. The elements outside of a DSCR loan are the investor’s target return and the length of the hold period. These elements, intrinsic and extrinsic to the loan, must be evaluated to determine the best loan type for the investment.
Asset-based lending on stabilized residential properties offers interest-only, fixed rate, and ARM options. Each of these types focuses on the coverage ratio of the NOI against the debt service.
Remember, the most competitive interest rate and leverage will be quoted for loans that allow a prepayment penalty. The investor’s hold period will determine the true effect of this penalty on the investment return.
A 30-year self-amortizing loan is set at a pre-determined rate evaluated at the time of underwriting. The rate remains the same over the term regardless of market conditions. The term “competitive rate” really means a few basis points between private lenders and not whole percentage points. Interest rates rise and fall across the lending markets and not between one or two lenders.
Interest-only loans for permanent money secured by a stabilized property will most likely not be for the life of the loan. The interest-only period could be for the first few years. The loan will begin to amortize at the end of the interest-only period. While this structure may temporarily relieve the investor in the early years, these loans are often quoted at a lower LTV and a higher interest rate.
A DSCR loan with the ARM structure will begin at a lower rate than the fixed and interest-only loans. While this loan type could prove profitable for an investor, timing and attention to detail are key. When the period of low interest ends, the adjustments will remain in place throughout the loan term.
When an investor considers an ARM loan, the period of the fixed low-interest payments must be weighed against the prepayment penalty and the exit plan. In this situation, the variable is the exit, and the unknown is the future market rates. The only component that can be adjusted is the investor’s exit.
Conclusion
Experienced investors need choices, and private lenders are the best sources for choices.
Private lenders will maintain the same flexibility in structuring the best long-term loan for the investor. With each opportunity, the investment strategies will be different for the investor and the lender.
The interest rate, fees, and costs determine a lender’s profit. This profit is fixed and illustrated by the APR. The investor’s profit remains unknown until the asset is sold with a lookback calculation of the cash flows.
The DSCR loan structures offered by private lenders will maintain the same flexibility regarding a shorter period between application and closing. The main driver of underwriting is the property’s performance with the investor’s credit score used only for establishing the quoted interest rate.
Investors needing long-term DSCR loans for their stabilized properties must seek a private lender with a transparent process and the flexibility to customize a loan specific to the investor’s objectives.
Ok, that’s it for today, we covered the topic of 9 elements that affect terms of DSCR Rental Loans and we hope you enjoyed reading.
