Happy February and welcome to this month’s edition of The Harbor Drive Investor! This week, the Federal Reserve (FED) met last week and voted to hold interest rates near historic lows….
We’re now a month into the new year and Harbor Drive Holdings is back on the hunt for the next investment opportunity! Putting on our Macro-Economic goggles, we are being particularly critical of projects with thin cash-flow. With most real estate markets enjoying a strong bull run over the past decade since the real estate and financial crisis of 2008 and 2009, most experts agree that we are closer to a real estate market correction than ever before in this phase of the cycle. However, experts have wildly different opinions about when a real estate downturn may come. Some experts believe a slowdown may occur in the next 12-24 months, while others think this train will keep steaming along the tracks for another 3-4 years if the FED keeps interest rates low. There is a relatively positive correlation between interest rate movement and commercial real estate CAP rates and the general sentiment among real estate forecasters is that until the FED begins to increase interest rates, commercial real estate CAP rates will continue to remain compressed.
What does all of this mean??
Though a real estate correction in some form is not a matter of if, but when, there are steps we can take as investors to mitigate downside risk on an investment property. The most notable hedge against a real estate pullback is to ensure that you have strong property cash flow. Strong cash-flow can help to reduce an investor’s risk through economic downturns and other market bumps in the road. It’s more important now, than in any other phase of a real estate cycle to be sure any prospective real estate investment has strong in-place cash-flow.
DCR or DSCR
DCR (Debt Coverage Ratio) or DSCR (Debt Service Cover Ratio) are two terms we use on a daily basis when evaluating a prospective real estate investment opportunity. These terms are interchangeable and mean the same thing. This measures the ratio by which your cash-flows cover your debt service (payments). The calculation looks like this:
NOI (Net Operating Income) / Debt Service Payments = DCR (Debt Coverage Ratio)
Example: If we have a property that has an annual NOI of $150,000 and annual debt service payments of $110,000, our DCR would be 1.36 and the equation would look like this:
$150,000 (NOI) / $110,000 (Debt Payments) = 1.36 DCR
Put in other words, the DCR measures how many dollars of operating cash flow a deal has for each dollar of debt service. In the example above, for every $1 of debt payment, there is $1.36 of cash flow. Agency lenders Fannie Mae and Freddie Mac are two of the nation’s largest apartment debt providers. Typically, their minimum DCR on a deal in a primary market is 1.25 DCR. If a DCR is any lower than 1.25, the agency lenders would either require less leverage, or just wouldn’t be interested in lending on that property causing the investor to seek lending through other channels (CMBS, Life Insurance Debt Funds, Bridge Lenders, Regional or Community Banks, etc.).
To summarize, the higher the DCR is on an investment deal, the healthier the cash-flow.
Harbor Drive Holdings’ Target DCR
As mentioned above, in today’s real estate climate and considering that we’re in the late stages of the expansion phase of this cycle, it’s more important now than in any other phase of the cycle to have strong cash-flow. We look at dozens of investment opportunities every single week and when Harbor Drive Holdings is evaluating a prospective real estate investment, we target a DCR of 1.5 or higher. Not only do we feel this helps reduce the investment risk when a real estate correction inevitably comes, but higher DCR ratios on a deal will typically give you more favorable lending terms including rates, leverage, and the ability to finance some or all of our planned capital improvements as opposed to having to bring that equity into the deal.
If you are a current investor in one of our real estate investments, or interested in learning about how you can participate in one of our upcoming investment opportunities, please reach out as we would love to connect with you and learn more about your investing goals!
Have a great month and as always, Happy Investing!
FYI…
In September of 2019, the Federal Housing Finance Agency revised it’s loan purchase cap structure for Fannie Mae and Freddie Mac. The new multifamily loan purchase caps will be $100 billion for each Enterprise, a combined total of $200 billion in support to the multifamily market, for the five-quarter period Q4 2019 – Q4 2020. The new caps apply to all multifamily business – no exclusions.
