Leveraged Breakdowns

Four Key Ratios to Evaluate Downside Risk

As global financial market volatility continues to rattle investor sentiment, and the possibility of a recession looms, commercial real estate markets have begun showing signs of a slowdown. This is a clear deviation from the commercial real estate industry’s trajectory over the last decade, which was characterized by cheap debt, steady rent growth, and increasing property values year over year.

This seemingly endless upward trajectory over the last decade resulted in many real estate investors opting to maximize their leverage to reduce equity requirements and boost returns. Unfortunately, current market conditions have put at risk previously underwritten assumptions for many deals acquired over the last few years.

Given this rapidly changing investment landscape, we review four ratios that help investors quantify risk and determine the optimal leverage ratios that should be used for new acquisitions. These metrics include break-even occupancy, operating expense ratio, debt service coverage ratio, and the loan constant

Break-Even Occupancy

The break-even occupancy ratio describes the minimum property occupancy level needed to cover all operating expenses and debt service payments in a given period before cash flow goes negative. An occupancy level below this break-even threshold results in additional equity needing to be injected in order to fund the operating shortfall. This metric is typically utilized by lenders when underwriting a property in order to assess downside risk. 

Break-Even Occupancy is calculated as follows: (Operating Expenses + Debt Service) / Gross Rental Income

For example, if an investor acquires a property with expected year 1 operating expenses of $240,000, annual debt service of $160,000, and a gross rental income of $500,000, what is the break-even occupancy? 

Break-Even Occupancy = ($240,000 + $160,000) / $500,000 = 80%

In general, lenders require a break-even occupancy ratio of ~80% or less to feel confident in the property’s ability to continue making debt service payments given fluctuations in occupancy. Although most common for multifamily properties, this metric is useful across all property types to quantify downside risk. Note that for properties with more variable occupancy and cash flow profiles (i.e. hotels or senior housing) the targeted breakeven occupancy is much lower than 80%, in order to provide for additional cushion. 

Operating Expense Ratio

The operating expense ratio is a metric that describes the annual operating expenses of a property in relation to effective gross revenues (or revenues after deducting vacancy and credit losses). It represents the percentage of effective revenues that are utilized to pay for operating expenses. This ratio helps investors understand how a property’s operations compare to similar properties in a given market, and can highlight potential problem areas or operational inefficiencies.

The Operating Expense Ratio is calculated as follows: Operating Expenses / Effective Gross Revenue

For example, a property with $200,000 in operating expenses and effective revenues of $500,000 has an operating expense ratio of 40% ($200,000 / $500,000 = 40%).

This ratio can be taken a step further to analyze how individual expense items measure up as compared with the property’s overall expense load. This would help an investor flag specific expense items that warrant further attention if they fall outside of the expected boundaries. 

Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio (or interest coverage ratio for interest-only loans) describes the ratio between a property’s annual net operating income and its loan debt service. This metric is typically expressed as a multiple and is representative of how many times over the net operating income can cover the debt obligations of the property. Thus, a DSCR of 1.25x means that the net operating income is 1.25x (or 125%) larger than the annual debt service of the property. 

The Debt Service Coverage Ratio (DSCR) is calculated as follows: Net Operating Income / (Loan Interest + Amortization)

For example, a property with a net operating income of $100,000 and a debt service total of $80,000 would have a DSCR ratio of 1.25x ($100,000 / $80,000 = 1.25x or 125%).

Given the ratio above, this would mean that the property’s NOI can decline by a maximum of 20% before the cash flow of the property would no longer be able to pay debt service using property NOI. Note that lenders typically require a DSCR of at least 1.20x when sizing up loans on properties, which provides cushion for a 16%-17% decline in property NOI.

Loan Constant

The loan constant (or mortgage constant) is a metric that shows the relationship between the annual debt service payments in a given year in relation to the loan’s outstanding balance. This is helpful for an investor when comparing various financing facilities. An investor can also compare the loan constant to the going-in cap rate to ensure the loan will not result in diluted returns due to negative leverage (see more about negative leverage here). A lower loan constant means that the borrower has a smaller debt service obligation, increasing cash flow to the investor.

The Loan Constant is calculated as follows: Annual Debt Service / Loan Amount

Thus, a property with $250,000 in annual  interest and amortization payments and a $5,000,000 loan amount has a loan constant of 5% ($250,000 / $5,000,000 = 5%). 

Final Thoughts

In real estate investing and particularly in real estate lending, it’s important to ensure that deals have a margin of safety. A margin of safety provides a cushion for investment assumptions in the event that things don’t go as smoothly as expected. The above four ratios help real estate investors assess a deal’s downside risk and ensure that the deal is structured to remain resilient in the face of potential downturns or uncertainties ahead.

Looking to learn more? Check out our various professional resources! Whether you have yet to break into the industry or are just starting out in a new role, we have everything you need. All you need to bring is your effort!

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