Usually, in the real estate world, when the debt service coverage ratio is up, the loan to value ratio is down, and that's considered a good thing. Lately, however, many lenders and borrowers are confronted with mortgage loans that have both high DSCRs and LTVs. The property is cash-flowing but, at least on paper, the owner has little or no equity. Understanding this conundrum is not difficult. Figuring out what it means depends on the circumstances of each situation.
High DSCRs are likely to occur when properties are fully leased and considered stabilized, and if the interest rates are relatively low. It helps, of course, if the LTV is low, because that implies that a reasonable amount of money was borrowed compared to the property's ability to pay debt service.
Despite the doom-and-gloom atmosphere surrounding real estate investments, many properties are, in fact, well-leased and stabilized. Interest rates are at a historically low, borrower friendly level. This is particularly true for floating rate loans tied to indices such as LIBOR, especially if the rates have no floors. In this market, even if debt levels are so high that LTVs approach or exceed 100%, interest rates are so low that they can lead to reasonable or even high DSCRs.
So what should a lender, or a borrower, do if DSCR and LTV are up? Well, it depends. Loan maturity is clearly a paramount issue. Assuming a well-leased, stabilized property is in a good location, it is likely that currently depressed values will rebound at some point. If the loan does not mature in the next year or two, one could take a wait-and-see approach, in hopes that rising values will rectify the problem and the "new normal" environment will allow property owners to refinance or sell with enough proceeds to payoff the existing loan.
Clearly, understanding what the real LTV is plays a big role in deciding whether waiting for the "new normal" to emerge is a good strategy. An appraisal done at the time of acquisition in, say, 2006 or 2007 is not likely the best guide to the property's current value, given that all property types in all locations have seen value declines in the last two years (clearly some more than others). It is also realistic to suppose that appraisals done during the period of "irrational exuberance" may have resulted in values on the high side of the market range.
While it is difficult to determine values precisely in the current market because there have been few transactions to use as reliable comparables, it is important to get as clear a picture as possible of the current property values. A 90% LTV is high, but not as bad as a 120% LTV. Understanding where the value is now is helpful because it leads to the obvious next question. How much does the value have to improve before one can feel comfortable that the property can act as collateral?
Property type and geographic location are critical factors in determining when property values will increase. For example, although multifamily properties, by and large, have fared the best in this economy, there are areas of the US, such as Phoenix or Las Vegas, where there is so much competition from unsold condos and single-family homes that multi family is not as attractive, and returning to normal will likely take longer.
It is important to analyze the actual amount of cash thrown off after debt service. When interest rates are low, a high DSCR does not necessarily mean that a lot of excess cash is being generated. Although the loan payment may seem relatively assured, if the amount of excess cash generated does not provide sufficient funds to pay for tenant improvements or leasing commissions when leases expire, then the property may be on the brink of disaster.In the words of the famous song, appropriately enough written in 1929, it may be a while before we sing, "Happy Days are Here Again:' In the meantime, careful analysis of the factors underlying high DSCR and simultaneous high LTV is called for when making decisions in this market.
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