DCR or debt coverage ratio, is one if not the most important thing to factor when it comes to commercial financing. However, it is one of the most overlooked aspects so I thought I would touch upon it’s importance here.
Last month, I closed on a very difficult commercial deal – a 12-plex in Orlando, FL. When looking at it initially the numbers looked strong and keep in mind at first glance they always will as they are put together by the realtor to get it sold. It is not until I as the broker or the lender do further due diligence with proper numbers, backed up by P/L and rent rolls, that the true numbers come out in the wash.
On this deal, the current seller had only owned the property for 18 months, having bought it with two other bigger buildings in a bulk purchase. Being the smaller of the three properties, they did not give it much thought and thus did not pay attention to the numbers that the property was producing, which ultimately affected the cap rate, the cash flow and ultimately the DCR.
To complicate matters, the buyer had a 1031 exchange in place, which meant he has a short window of time to place the funds in trust that were from a previous sale, into a new property. It is a great way that Americans get to offset the capital gains. He and the realtor had been searching for available mutli-family properties for some time and came upon this supposed deal.
The first items I request on any commercial acquisition are 3 years P/L statements and 3 years rent rolls, which will give the overall picture of the health of the property. As the current seller had only owned it for 18 months, they were unable to product this and to further complicate things, they had combined the numbers on the 12-unit with the numbers of the two other properties – essentially it was a paperwork nightmare and they were refusing to separate the numbers.
I advised the buyer at this point to move on to another property, but with the looming deadline to execute the 1031 Exchange, he was not keen to move on and thus based the projections on what was possible rather than what the reality was. Furthermore, he also based his numbers on the cap rate, which is a market specific evaluation and not the DCR, which is more important as it tells the lender that the building can support itself.
There is a misconception when it comes to Commercial financing that the lender is only looking at the building to support itself and not the borrower. Unlike residential, where the borrower is looked upon less than the property – in commercial it is quite the opposite and the DCR shows the strength of the building to support the financials and mitigate against vacancies and the effect on cash flow.
I shopped the deal around and finally found a lender who was willing to offer 4.875% with 30-year amortization on a 10-year term. We struggled through due diligence to get the numbers in line with what little paperwork, we were able to obtain from the sellers, however we could not get the DCR above 1.13.
The building was great and in a great location with very little renovations required, however the low rents were a problem as we could not reach the minimum debt coverage ratio of 1.25. On any commercial acquisition in both Canada and the US, the lenders are looking for a min DCR of 1.25. Furthermore, with 3 vacancies, the seller did not place tenants at the required rent of $999 but rather at the lower end of the spectrum of $650, which further affected cash flow and DCR.
If you as the buyer are looking for a deal and see that there is room to force appreciation and/or turn-over the units to raise rents after renovations, you still must keep in mind that lenders are looking for a DCR of 1.25, in order to feel comfortable financing the purchase.
We closed but not under the terms originally promised. Unfortunately, the buyer had no choice but to close with a private lender at 11% interest only + 4 points, because not only would he lose the earnest money deposit of $100,000 but he would also lose the taxes of $100,000 on the 1031 Exchange.
He is now working on a 1-year plan to raise the rents so that the property will then have a DCR of 1.40, which will allow him to refinance for better rates and terms.
I am working on a new solution as we speak but it will take time so I hope to update you down the line, when we have a new lender on board.