Virtually all investors in the self-storage arena buy their properties using debt. That’s always been the attraction to real estate: the availability of getting leverage. And leverage is the tool that allows cash-on-cash returns to be stronger than traditional investments that have no leverage. One of the metrics banks use to underwrite loans is the “coverage ratio”.
What is a coverage ratio?
The “coverage ratio” is the amount of net income available to cover the mortgage, as a ratio in which the mortgage payment is considered “1 times”. This is often always called the “Debt Service Coverage Ratio (DSCR). The minimum DSCR can vary from bank to bank, but it typically is in the range of 1.25 times to 1.5 times the mortgage amount. This means that the asset can produce roughly an additional 25% of income after the debt payment.
Why is it important?
Banks will not typically make loans that have a DSCR of just “1 times”. The reason is that they feel they don’t have the necessary protection in case the property should hit a bump in the road. The current virus quarantine has hammered that point home for many lenders, who are watching the potential for huge losses in the lodging, retail and office industries. The bottom line is that the greater the DSCR the greater the chance that the bank will be comfortable with your loan.
Putting this to good use
When you are trying to figure out the price on a self-storage property it is important to approach it as a lender would. Since we know that the lender is focused on, among other items, a DSCR of around 1.25 or greater, it makes sense to use this analysis on the front end. Never approach a lender when your DSCR is just barely at “1 times” as it will not be attractive to them and a non-starter. To get a loan you must present a compelling loan package, and that equates to a DSCR that is typically 1.25 or greater.
Are there exceptions to this rule?
Sure, just as there are in everything. But it still has to tie back to a favorable DSCR in the end. For example, if the storage property has some immediate cost cutting that can be done after purchase, then that would increase the DSCR. The same would be true if you have immediate increases possible in revenue due to rent increases or greater social media marketing, for example. These improvements need to be noted in your loan package. In addition, it never hurts to emphasize this increase in DSCR after closing, even if the deal was at 1.25 on the front end.
Conclusion
To your bank, the DSCR is a big deal and that means it should be one to you, too. Understand its meaning and performance metric and you will be a better borrower and more successful in your loan applications and discussions. A happy bank is a happy thing when buying storage properties.