A very important concept that is inexorably tied to student housing financing is the Debt-Service Coverage Ratio or DSCR. Not only must college and university chief financial officers understand this, but all senior housing officers should also know what this is as well in order to fully appreciate the financial requirements and ramifications that come with borrowing money in order to develop, construct, and operate new student housing. This post will explain the basics behind the Debt-Service Coverage Ratio and how it impacts that day-to-day operations of managing student housing communities.

Investopedia defines the debt-service coverage ratio as follows: “…the debt-service coverage ratio (DSCR) is a measurement of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments.”

While the definition may sound complicated, the DSCR is essentially an annual calculation that illustrates whether or not you have enough funds to cover the payments for the money you borrowed. When an institution borrows millions upon millions of dollars to construct new student housing, the lender needs reassurance that the project is financially healthy enough to make the required payments on the debt (i.e., debt-service). Just like any loan, there is the expectation that the money borrowed will be paid back by the agreed-upon terms (i.e., length of loan, interest, etc.) In this particular case, because it’s a real estate-based transaction, the lender uses a DSCR test as a means to set a benchmark for what is acceptable from a cash flow standpoint.

One important distinction, however, is that the lender expects a project to be more financially successful over simply just earning enough money to cover the debt payments. They want to see that a project is operating prudently so that there is enough money remaining over and above the annual debt payment amounts. A student housing project that is essentially living “paycheck-to-paycheck” (or not even to that level) is a huge financial risk, which lending institutions attempt to avoid. Having sufficient cash flow permits the ability to make the principal and interest payments, pay for operational costs (e.g., personnel, facilities maintenance, etc.), set aside funds for capital projects (i.e., building and property improvements), and still have some money remaining.

Therefore, a lender will typically require an annual debt-service coverage ratio (DSCR) of 1.20, which is generally a national industry standard. This means that, overall, the income must be 120% of what the annual debt service requirements are. This extra amount up-and-above the debt-service is essentially a buffer. Understand that the lender does not keep this extra amount, but simply uses this as a annual requirement to make sure that the administrators of the housing project are managing it soundly. The borrower must illustrate annually what the DSCR is via required financial statements and budgets provided to the lending institution.

The DSCR is calculated in two different steps: 1.) First, subtract the operating expenses from the revenue earned to obtain the Adjusted Income; and 2.) Second, divide the Adjusted Income by the Debt Service Requirements to calculate the Debt-Service Coverage Ratio (DSCR). Let’s look at a successful theoretical calculation from a fictional 400 bed student housing community. Please note these numbers are just for illustration’s sake:

Revenue Earned – Operating Expenses = Adjusted Income

$2,400,000 – $1,200,000 = $1,200,000 Adjusted Income

Adjusted Income ÷ Debt Service Requirements = Debt-Service Coverage Ratio

$1,200,000 ÷ $1,000,000 = 1.20 DSCR

As you can see, this fictional student housing community meets the 1.20 DSCR test. In this particular case, they are exactly meeting the mark for what is financially required. 

Now let’s look at the same 400 bed, student housing community, but reflecting less income earned (i.e., lower student occupancy), but the same level of operating expenses:

Revenue Earned – Operating Expenses = Adjusted Income

$2,250,000 – $1,200,000 = $1,050,000 Adjusted Income

Adjusted Income ÷ Debt Service Requirements = Debt-Service Coverage Ratio

$1,050,000 ÷ $1,000,000 = 1.05 DSCR

As you can see in this example, they are clearly below the required 1.20 DSCR by $150,000. While they would still be able to make the debt service payments, they would still be scrutinized for not meeting the debt-service coverage ratio test. This can cause some proverbial alarms to sound as the DSCR test not being met could be symptomatic of one or a combination of many factors, including, but not limited to, poor asset management, new competitors in the local market, enrollment issues at the institution, and financial mismanagement. Because of this, the financiers can require various remedies to occur, including financial and management advisers to scrutinize all operations because they would not want this trend to continue into subsequent financial years.

In some dire situations, the DSCR can go below a 1.00, which essentially means that the housing community is not only unable to meet its debt obligations, but neither its budgeted operational expenses as well. At the end of the day, the only way to remedy a DSCR lower than a 1.20 is to increase revenue and / or decrease expenses. However, it’s important to understand that you cannot “cut” your way to financial success; you cannot make enough cuts to make up for the revenue that you are not earning. You must be able to earn enough revenue to meet the debt requirements. As with the case of the 1.05 DSCR example, attempting to cut $150,000 from the operational budget of a 400 bed community is going to next to impossible without significantly altering the services provided. This is why maintaining a strong occupancy is crucial. If, theoretically, the average fee for an academic year of housing costs $8,000 per student at that community, only 19 additional housing contracts would need to be obtained in order to meet the debt service requirements. 

While there are others nuances and operational strategies in order to meet the debt-service coverage ratio, the key is making sure that your occupancy levels generate enough income to cover both the principal and interest payments as well as operational costs. 

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*Photos courtesy of Marcelo Moura and Ayhan Yildiz.