Metrics that Matter #12: Cap Rate and Debt Service Coverage Ratio (DSCR)
Written in Partnership with Shane Connor from Bull Realty
As an Executive Director, you’re responsible for delivering positive net operating income (NOI) at your community. You’re likely 100% focused on the day to day, but it’s also essential to keep an eye on the overall economy (specifically interest rates) to understand how the community’s owners are evaluating your success.
Today’s post will explain why small changes in NOI can have a HUGE impact on how owners and investors value your community. We teamed up with an expert for this post: Shane Connor from Bull Realty, a senior living real estate specialist.
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Prior to 2022, interest rates were generally stable, and were coming off a period of historic lows. Many owners financed buying communities with a floating rate loan, which means that their interest rate went up or down depending on the standard interest rate. When interest rates were stable, the monthly interest payment (or debt payment) was generally the same month to month.
Starting in 2022 The Federal Reserve began to raise interest rates rapidly in an effort to combat elevated levels of inflation. This meant that monthly payments went up for any loans that were priced on a floating rate basis! This is where our 2 new metrics come into play:
Cap Rate: the expected rate of return on a real estate investment if an investor was to purchase in all cash. Usually stated as a percent. (FYI: The topic of Cap Rates could warrant an entire post on its own, but for simplicity we will say that *in general* Cap Rates tend to follow the cost of borrowing capital).
Debt Service Coverage Ratio (DSCR): a measure of how healthy the business is. Calculated as NOI divided by debt (the interest payment or debt). Lenders (like banks) track DSCR to measure whether a community could pay back its debt via the cash flow (measured by NOI).
Now that we have the formal definitions out of the way, let’s talk about why Cap Rate and DSCR matter!
As interest rates are rising, the monthly interest payment is also going up. This means that total expenses are going up, so even if your revenue and other expenses stay the same, you still have less “room” in your budget!
In this environment owners scrutinize all expenses (down to the hundreds or even tens of dollars) VERY closely. As an ED, you might find it frustrating that an owner is pushing back on a seemingly minor purchase (say $1000 / month). However, this purchase can have a BIG impact on the DSCR and overall valuation of the community (which is tied to cap rate).
Here’s an example: let’s say there is a $10K / month increase in costs due to agency staffing. This eats into NOI, and if the ratio of NOI / monthly debt falls below 1.3x DSCR or a similar threshold in the loan covenants, the community may be at risk of defaulting on their loan as well as have a harder time if seeking to recapitalize. From a valuation standpoint (how much the owner could sell the community for), you could use an example of an 8% market cap rate for each dollar of NOI. So in this example one would divide $10K by 8% and estimate that this additional $10K in costs per month could reduce the valuation of the community by $1,500,000! Now imagine if every community in the owner’s portfolio is having similar expenses - you can see why this is a big deal!
The senior living industry combines healthcare, hospitality, and real estate. While it may seem like the real estate side of the business is only relevant to owners, you can see from the examples above that it has a huge impact on EDs as their ability to manage NOI can have a huge impact on the financial stability (and value) of their community.
We hope that this post has “demystified” the real estate side of the business. Our goal is to explain complex topics in simple, relatable, terms and build empathy between everyone in the industry so that they understand each other better and can work together as a team.