Some of the most important numbers in the commercial real estate and multifamily industry are NOI (Net Operating Income), DSCR (Debt Service Coverage Ratio), and DY (Debt Yield) — especially on the lender side. Because it is so important to lenders, borrowers have to constantly calculate these numbers and keep a meticulous record of them. This is done through lender reporting.
First things first, let's break down these loan metrics so it's easier to understand why lenders care about them so much.
Net Operating Income = Revenue - Expenses
- The real estate version of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), your NOI is how much you made without taking into account your debt service (how much you owe in loan payments) or taxes. Like any other number that indicates income, the higher the number, the better. While it is usually quoted as an annualized number, it can also be monthly, quarterly, etc.
Debt Service Coverage Ratio = NOI / Debt Service
- DSCR illustrates how easily a borrower can cover payments back to the lender; it demonstrates how much the borrower has left over (after expenses) to pay back their debts. The higher the ratio, the bigger the cushion the borrower has, after expenses, to pay off their debts — it indicates a higher cash flow (a higher NOI). For example, a DSCR of 1.0x means the borrower made just enough to pay the lender back. But 2.0x means they made twice what they owe back to the lender.
Debt Yield = NOI / Loan Amount
- Debt Yield is similar to DSCR as it indicates how strongly/poorly the loan is doing — the risk associated with the loan. But unlike DSCR, debt yield is independent of the interest rate, amortization period, and market value. It only takes into account the amount left on the loan itself. The higher the amount borrowed (the leverage), the higher the risk and the lower the debt yield. If the borrower defaults on the loan and the lender has to foreclose, debt yield is the return the lender would receive.
Knowing now what each of these metrics measure and how they're calculated, it's easy to see why they're so important to lenders. They demonstrate how likely the borrower is to pay back their money!
But there's a twist! Lenders have nuanced adjustments for these metrics written into each loan — and we mean nuanced. These terms make lender reporting extremely complicated for the borrowers because no loan has the same adjustments — every loan has different conditions that need to be taken into account and the conditions in place are unpredictable.
On The Borrower's Side
Ever so often, lenders require their borrowers to prove that they are on track with their metrics.
Some of our clients shared what they go through to do this...
At least once a year (usually quarterly) they spend an hour or so on each loan, updating the numbers.
They manually dig through loan docs for their required NOI with adjustments and subsequently dig through their accounting line items to find the numbers required for the adjustment. With screenshots upon screenshots of loan docs and property reports at their disposal, they have to pull the lender-adjusted definitions for NOI (and Debt Service) to calculate a new DSCR and Debt Yield before shipping everything off to their lender, every reporting period.
All in the name of covenant tracking.
We go through thousands and thousands of loan docs and have seen our fair share of required reports and adjustments.
For multi shops, and sometimes mixed use buildings, we see a lot of lenders requiring monthly Rent Rolls. For value add or construction loans, we often see required Compliance Certificates that specifically request evidence they are meeting DSCR, LTV, and Debt Yield covenants.
We also see a lot of lenders looking for Balance Sheets, Income or Expense Statements, Tax Returns, and Operating Statement reports.
As for the adjustments, definitions for NOI and Debt Service are unique mixtures of different adjustments, but some appear more often than others. A few recurring ones include replacement reserves, management fees, and occupancy/vacancy rates.
We've even started seeing lender's consultant sections written into loan docs that give lenders the right to employ advisors!
What are the consequences of lender compliance failure?
Fines, fees, foreclosure, lawsuits, you name it. There are many consequences for borrowers if they fail to abide by the covenants written in their loan docs so they send their lenders whatever is necessary to stay in compliance.
No matter how tedious or complex.
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