How to negotiate your debt service coverage ratio

Our “On Finance” columns often focus on macro issues such as mortgage loan availability, fixed- and variable-interest-rate costs and options and the like. This column will not do that; rather, it will discuss an “in-the-weeds” mortgage clause that could, years into the loan term, cause you real heartburn if not wisely negotiated.

Recently, I received a notice from a lender that spurred me to write this column, one that I hope you will keep in mind when negotiating your next mortgage-financing deal. A portion of the letter read: “There was also a question on distributions coming out of your hotel. As a result of the distributions, the post-distribution cash flow covenant for your hotel is being violated under the loan’s debt service coverage ratio (DSCR) formula. Covenant is 1.0x coverage.”

Though the lender’s analysis was inaccurate, and the loan officer was pleased that I corrected the record, had his assertion proved accurate, the bank would have been entitled to put my loan into default, with all sorts of nasty consequences.

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So, what is a DSCR ratio and why is it important to the lender? Briefly, a lender wants to be continually assured that the income-producing property it financed is producing sufficient cash flow to cover the mortgage debt service payment, often with a cushion of extra cash flow, for safety’s sake. For example, say you’ve got a hotel with a $5-million mortgage that has annual debt service of $400,000 to cover principal and interest. If your business is generating $400,000 of profit before debt service, then your DSCR is 1.0; if your business is generating $800,000, then the DSCR is 2.0.

It’s apparent from this example why the lender usually requires a DSCR mortgage clause. Often, when it initially negotiates this “property-performance clause” it will start by proposing, say, a 1.5 DSCR. In the above example, that’d mean the borrower would need to earn a pre-debt service profit of at least $600,000, from which $400,000 debt service would be paid; if the property only earned, say, $500,000, while the mortgage debt service would have been paid, the loan could still be declared in default. Incidentally, lenders will often include in the DSCR formula a pro forma deduction from net profit for items such as management fees and FF&E replacement reserves (based on percentages of gross sales), whether those sums are actually paid or not.

➔ Given the ups and downs of annual hotel cash flow, if you have insufficient profit (or loss) during any year, once the lender reads your financial statement it may well be entitled to declare your loan in default.

Given the ups and downs of annual hotel cash flows, if you have insufficient profit (or loss) during any year, once the lender reads your financial statement it may well be entitled to declare your loan in default. It could then make demands on you such as “pay off the loan”, “pay down principal on the loan”, “personally guarantee all/a portion of the principal”, and the like.

Knowing these potential outcomes, here are some suggestions to assist you in negotiating DSCR clauses up front so that you don’t find yourself with a serious mortgage default problem down the line, even though you are, in fact, making your mortgage payments:

1 Keep your hurdle rate as close to 1.0 as possible;

2 Propose that the DSCR test use an average of, say, two years net income numbers rather than just one test year;

3 Offer to put cash, or other assets, in escrow to cover a hurdle rate deficiency until the business profit exceeds the DSCR test rate; this, rather than a principal pay-down on the loan, since it’s likely that a lot less cash will be required;

4 Propose having the lender do an appraisal in the event of a DSCR deficiency and agreeing that so long as the appraisal equals, say, 125 percent of the mortgage level, the default will be waived (remember, an appraisal values a stream of multiple future years’ net incomes, rather than simply last year’s results).

In closing, know that the lender has little interest in placing a loan into default status since doing so may well result in it having to place the loan in a “scheduled category.” That may have negative implications for the lender when the government examiners look over the mortgagee’s books and records. So, the negotiating loan officer does have an interest in agreeing to a practical DSCR clause with you, one where you don’t feel you have the Sword of Damocles hanging over your head during the life of the loan.