For many years , banks have used the Debt Service Coverage Ratio [ DSCR ] as a way to access risk regarding the viability of a borrower to make mortgage payments after subtracting normal expenses from income . The larger the ratio , the more comfortable the bank felt making a loan . For example , let ’ s presume that a borrower was considering applying for a $ 650,000 loan amortized over 20 years at 4 % with a bank . The monthly payment would be about $ 3,939 per month . If the apartment building grossed $ 8,000 and the normal expenses were $ 3,000 per month , the Net Operating Income [ NOI ] would be $ 5,000 per month . The DSCR would be 1.27 [$ 5,000 /$ 3,939 ]. Of course , the bank would also look at the Loan to Value [ LTV ] in conjunction with the DSCR . Presuming the value of the apartment building was $ 1,000,000 , a 65 % LTV loan would be acceptable to most banks .
In previous years , a lot of banks were willing to allow a DSCR as low as 1.00 , meaning that the NOI exactly covered the banks monthly payment ; however , after The Great Recession in 2008 , banks pulled back substantially in their lending practices and raised the DSCR to 1.15 , then 1.25 , and then many settled on 1.35 . This severely constrained many borrowers ’ ability to finance their real estate projects . They either had to come up with more cash , or they had to negotiate for a longer term [ 25 or possibly 30 year amortization periods ] as well as requesting a lower interest rate . The combination of increasing the amortization period and lowered interest rates allowed borrowers to borrower the amount they initially requested in order to meet the more stringent 1.35 DSCR .
The problem with the above negotiations [ from the bank ’ s perspective ] is that the bank was still at the same LTV , and , in fact , one could argue that the bank was not compensated for the benefit bestowed upon the borrower [ lowering the rate and / or stretching out the amortization period ]. Just because the borrower met the new DSCR requirement did not put the bank in a safer position . In addition , the problem with the DSCR is that it only addressed the ability of the borrower to make the monthly mortgage payment . It does not address the LTV risk for the bank or give the bank a ROR should the bank be faced with foreclosing on the property .
Prior to 2008 , banks were willing to lend at a high LTV . Historically , 6065 % was the norm ; however , with competition came increased LTVs . Lower interest rates appeared to assist the bank with risk due to the relatively low [ historical ] mortgage payments . However , when prices dramatically decreased , many lenders were faced with borrowers who were upside down on their loans . The banks needed to figure a new way to assess risk for future loans .
Image by mohamed Hassan from Pixabay
What is the Debt Yield Ratio that Banks are now using ?
By Edward Brown
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