Cash-Out Refinance With a Razor-Thin DSCR Covenant
An owner is weighing a cash-out refinance of a 48-unit apartment building whose NOI is $412,000 and trending flat. The existing loan carries a $3,100,000 balance at 4.25% with annual debt service of $248,000; the lender quoted $140,000 of defeasance to retire it early. A new lender offers 6.75%, 30-year amortization, a 10-year term, a 75% LTV ceiling and a 1.25x minimum DSCR, with loan costs of 1.5% of the new loan. The appraisal is $5,600,000. The owner needs $650,000 in the next 24 months for roof and window replacement; cash reserves are $95,000. The new loan carries an annually tested 1.25x DSCR covenant, and the owner wants to know how much risk that covenant creates.
1. Size the maximum loan under each lender constraint and identify which one binds. What DSCR results at the maximum loan?
Read the worked answer
Monthly payment factor for 6.75%, 30-year amortization: 0.0064858 per $1 of loan (about $77.83 per $1,000 per year).
DSCR constraint
- Permitted annual debt service = $412,000 ÷ 1.25 = $329,600, or $27,467 per month.
- Maximum loan = $27,467 ÷ 0.0064858 ≈ $4,235,000.
LTV constraint
- 75% × $5,600,000 = $4,200,000.
Result: LTV binds. At a $4,200,000 loan, annual debt service is $4,200,000 × 0.077829 ≈ $326,900, and DSCR = $412,000 ÷ $326,900 = 1.26x.
The DSCR is only 0.01x above the covenant - effectively no headroom. Note also that the loan amortizes only to roughly $3,580,000 by the year-10 maturity, leaving a balloon that must be refinanced at whatever rate exists then.
2. Compute net cash out and the change in cash flow. Is the $650,000 capital program funded?
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Net proceeds
- New loan: $4,200,000
- Less payoff: ($3,100,000)
- Less defeasance: ($140,000)
- Less loan costs (1.5%): ($63,000)
- Net cash to owner: $897,000; plus existing reserves of $95,000 = $992,000 available against a $650,000 need, a $342,000 cushion.
Cash flow impact
- Before: $412,000 − $248,000 = $164,000.
- After: $412,000 − $326,900 = $85,100.
- Cash flow falls about $78,900 per year, so the owner is borrowing roughly $1.1 million more than the existing balance and paying $78,900 a year for it - an incremental cost of debt near 7.2% before any amortization benefit.
So the capex is funded, but the owner has traded a 66% DSCR for a 1.26x covenant, added $78,900 of annual fixed cost, and shortened the effective life of the debt to a 10-year balloon.
3. Recommend a course of action. Quantify the NOI decline that would breach the covenant.
Read the worked answer
Breach point: covenant NOI = 1.25 × $326,900 = $408,600. Current NOI is $412,000, so a 0.8% ($3,400) decline triggers a technical default - well inside normal year-to-year volatility for a 48-unit property.
Recommendation:
- Do not take the maximum loan. Request a structure that holds DSCR at 1.35x: permitted debt service = $412,000 ÷ 1.35 = $305,200, which supports a loan of $305,200 ÷ 0.077829 ≈ $3,920,000. Net proceeds would be about $622,000 plus $95,000 of reserves ≈ $717,000 - enough to fund the $650,000 program with a small cushion.
- Before paying $140,000 to defease, ask the existing lender about a modification plus supplemental financing. The existing 4.25% debt is 250 bp cheaper than the new quote; extinguishing it to capture cash at 6.75% destroys value on the retained portion of the balance.
- Phase the capex (roof first, windows in year two) to reduce the peak draw, and negotiate a covenant holiday or a cure right during construction.
- If the lender will not move off 1.25x, a smaller loan plus a reserve-funded capital plan is preferable - the covenant, not the interest rate, is the real risk in this deal.