Here we’ll explore what a debt service coverage ratio (DSCR) represents and the role it plays in evaluating real estate investment opportunities.
DSCR is a measure of a borrower’s ability to repay a given loan with current assets. It represents the ratio of the net operating income of the property against the scheduled interest and principal payments on the loan.
There is always a risk that a borrower won’t be able to repay its debt. If this were to happen, having a real estate property in place as collateral can act as a safety net by preserving part or all of the lender’s principal. DSCR is a common metric used in the due diligence process to evaluate key characteristics of the collateral and borrower. It helps to validate that the borrower has the means necessary to support the loan throughout its duration. For example, if a property has $1.25 million in annual net operating income and $1 million in annual loan payments, the DSCR is 1.25x, indicating the borrower has more than enough income to cover its debt service.
YieldStreet aims to maximize capital preservation for investors while generating attractive returns. As such, YieldStreet looks for a DSCR around 1.0x.
Let’s say an originator, ABC Funding, has closed on a $15 million real estate bridge loan to a borrower, Scott Associates, an experienced real estate owner and operator. The loan is collateralized by a mixed-use property that will be renovated into high-end condo lofts with retail space on the first floor. The property is not expected to generate income during the term of the loan, as it will be undergoing renovations—which means the initial DSCR calculation equals 0.0x.
However, in this scenario, since there is no operating income to service the loan, as an alternative ABC Funding has required Scott Associates to fund an interest reserve at the loan’s closing. An interest reserve is an upfront payment of all or part of the amount of interest owed over the life of the loan. Scott Associates has agreed to fund an interest reserve with 100% of the interest payments at loan closing. Because any funds in an interest reserve are added to the net operating income of the property, the resulting final DSCR is 1.0x.
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