Tougher DSCR Ratios: How Landlords can meet refinancing challenges

What is the Debt-Service Coverage Ratio (DSCR) and why is it important?

The Debt-Service Coverage Ratio (DSCR) is a financial metric that shows a property’s ability to cover its debt obligations. It is crucial for lenders as it helps assess the property’s ability to generate enough income to repay debts, indicating the property’s financial health and risk level.

Commercial Finance Director Miles Wallace explains that while there are challenges in the sector even the most experienced of landlords can benefit from working with an experienced finance broker to overcome this problem.

Portfolio Landlords often face challenges when it comes to refinancing their investment properties. One of the key factors for lenders in the refinancing process is the debt service coverage ratio (DSCR).

DSCR is a financial ratio that lenders use to measures a property’s ability to generate enough cash flow to cover its running costs and finance payments.

Lenders view DSCR as an important risk metric. A property- or a portfolio of properties- with consistently high DSCR is perceived as lower risk for a loan. So, maintaining a solid ratio is key to securing favourable mortgage terms over time.

Right now, following a period of relatively low interest rates, we are seeing a number of portfolio landlords coming to the end of their preferential fixed rate deals and having to refinance with much higher mortgage rates, which makes their borrowing costs higher, their net yield much lower and gives them a poorer DSCR.

Typically, those that have held their stock for ten years have relatively low gearing across their portfolio because they have enjoyed a cycle of low borrowing rates- but, sadly, it’s these landlords that are being hit hardest.

Bank of England base rate

The increase in interest rates is caused by the changes in the Bank of England base rate. Sometimes referred to as the bank rate or base interest rate, it is the most important interest rate in the UK.

It is used by the Bank of England primarily to control inflation, but it also influences all loan and mortgage interest rates in the UK.

When the Bank of England decreases the base rate, interest rates usually follow suit, meaning borrowing gets cheaper – but conversely if it goes up, as it has done each quarter since late 2021, so do mortgage or loan rates, increasing landlord’s costs and decreasing their rental profits.

The current Base Rate (at Feb 2024) is 5.25%, it has risen steadily – from a low point in March 2020 when it was set to of 0.1% to try and help the economy survive the impact of the coronavirus pandemic- to its current level, which is at its highest in recent times, but not considered exceptional historically.

This continual increase of course, has had a significant impact on annual yields and profit margin for a lot of portfolio and single-property buy-to-let landlords.

Increase in Rental prices

However, the upside is that the value of the rental market has increased astronomically in recent years.

While a steady 7% yield** was seen as a decent return, as demand continues to outstrip supply and tenants are prepared to offer well over market rate in some cases, the UK rental market has experienced an increase in rent of around 15 to 20 % per annum.

While this market may cool slightly in 2024, rents are still expected to increase by another 5% dependent on where the property is based.

Despite this increase in income, however, the increase in borrowing costs can mean some landlords, and some buy-to-let properties fail the tougher debt service coverage ratios (DSCR) imposed by lenders.

Calculating a rental yield

When looking to invest money in a property or add to an existing portfolio, one of the key factors for landlords and lenders alike is the likely return on investment and whether it will yield the expected revenues in terms of monthly rent compared to the value of the property or the price paid for it.

Calculating the rental yield can act as a benchmark to compare the performance of one property against others in similar or different areas, or even compare this performance to different types of investments. It is a key component of the DSCR calculation.

Yield is based on the property value and the rental income it can achieve.

For example, if a property is valued at £500,000 and can earn £35,000per annum in rental income, it represents a yield of 7%.

Gross yield in more fluid and in more desirable areas the yield can be as low as 3-4% compared to up to 10% in low property value and low employment areas.

However, high value and low yielding areas can offer strong capital growth, which some landlords focus more on.

As this represents the gross yield of a property however, there are a number of other factors developers, landlords and investors need to take into account to ensure the property is making a profit.

As well as rental income, landlords should also take into account other factors such as running costs or management fees or the likelihood of occupation to get a clear picture of whether they can expect a return on their investment.

We can advise clients on all of this and to help clients consider their preferred property model.

What is a good rental yield? 

This is a question we are asked a lot by new landlords. In truth there is no hard and fast rule as to what a good rental yield is, as returns will depend on many factors; the location of your property, its desirability, competition and demand and the amount needed to be spent to get it to a suitable condition.

As a very general rule, a rental yield of 7% on a residential property is considered very good, while commercial properties can be slightly higher from 8% upwards, but there are more costs involved with letting commercial property. These costs are offset by longer rental periods, as these leases typically range from two years to 10 years, and in many cases the tenants will be responsible for maintenance of the property.

Landlords must also factor extra costs into their budget. Monthly rent should be able to cover the running costs of the property as well as mortgage payments, but it should also make enough profit to build up an emergency fund should something happen at the property such as a broken boiler, as well as covering any periods when the building may be unoccupied- during an end of tenancy for example.

What is the average rental yield in the UK?

In 2023, the average rental yield on a UK residential property was 4.75%. Many areas, typically in the north of England, where purchase prices were relatively lower, offered a higher-yield and some less.

Whilst this is useful to know for benchmarking purposes, this isn’t necessarily applicable to all properties, in every area. It can also vary, depending on the layout and final configuration of a property and its occupation situation at the time of applying for finance.

For example, approaching a lender to lend against a property that has more than 90 days vacant possession will receive its lowest ever valuation, whereas a HMO with more than seven beds or a multi-unit block will command the highest possible valuation.

Imagine if you bought a pub that had been empty for months, and hadn’t had a customer in 10 years, or you buy a pub which has been trading for 20 years and is always full and has a good client base. The differences in value between the pubs could be massive.

Holiday lettings tax relief scrapped

In a move that may sway a number of landlords to rethink their investments, in the Spring Budget, the Chancellor announced that the furnished holiday lets (FHL) regime, which offers tax advantages to those who let out a furnished property as a holiday home, will be abolished in April 2025 & VAT becomes applicable from £80k turnover PA. From 10-20%. To help put this increased cost into context, the typical cost of running a holiday let is 30% of the gross income not including tax.

At the moment, landlords who use the furnished holiday lets regime for Airbnb type short-lets, can deduct the full cost of their mortgage interest payments from their rental income.

While the intention may be to make more long-term lets more attractive and more available, this will of course increase the overhead costs to landlords across the UK that operate this model

Property tax

In a move to perhaps soften the blow for portfolio landlords, the Government also announced that it will now reduce the higher rate of property Capital Gains Tax from 28% to 24%, which the Chancellor said he hopes will increase revenues by encouraging more transactions.

He also confirmed the abolishment of ‘multiple dwellings relief’, a stamp duty relief for people buying more than one property at the same time, saying the scheme shows “no evidence of promoting investment in the private rented sector”.

Again, this legislation update will have a profound impact on landlords.

Lots of Tenanted Stock Availability

There is however, cause for optimism for portfolio landlords. The price of property has increased significantly since Covid, increasing the requirements for rental properties and the value of assets, but also against this backdrop of higher fees and lower revenues, a number of portfolio and single property landlords will choose to sell off their stock – and do so for a fair price.

What is too expensive for one landlord, might fit well the portfolio of another.

For example, we have recently negotiated a deal for a landlord to buy 14 units in two blocks of flats in Cheltenham for £2.35 million.

While the existing landlord wanted to sell off the assets and get £2.3 million in the bank to ease their cash flow. We were able to negotiate the price based on a 6% yield, knowing full well that with a little refurbishment and a bit of TLC, this yield could increase to 9% based on that purchase price.

Everyone wins.

The point is that the market is moving and people are selling off what isn’t affordable for them, but what can be affordable for others, with the right experience and finance advice.

As a specialist finance broker with many years’ experience working with buy-to-let landlords, we have been able to package whole portfolios up into one loan, minimising the admin costs, minimising the impact of various lender’s rate changes.

We were recently able to consolidate a client’s debt into one loan across 125 flats; we reduced the interest rate by more than 60% and release £2 million worth of equity as part of the refinancing.

Calculating Your DSCR Ratios

Clearly several factors influence the debt service coverage ratio. These factors include interest rates, rental income, refurbishment and operating expenses. Understanding how these factors impact DSCR is essential for landlords seeking to refinance properties or portfolios this year.

The ratio is calculated by dividing the property’s net operating income (NOI), its rental value minus any management fees- by its debt – or cost of borrowing, which can be either on a repayment or more typically an interest only basis.

The debt service coverage ratio compares a property’s net operating income (NOI) to its total debt service obligations (TDS). It is calculated by dividing NOI by TDS.

For example:

• A multi-unit property earns £500,000 in gross scheduled income annually.
• It incurs £200,000 in annual operating expenses including a 5% vacancy allowance.
• Its annual loan payment consisting of £150,000 interest and £50,000 principal is £200,000.
• No other debt payments exist.

NOI = £500,000 Gross Income – £200,000 Operating Expenses = £300,000

TDS = £200,000 Total Loan Payment

DSCR = £300,000 NOI / £200,000 TDS = 1.5

So the property’s DSCR is 1.5, meaning its NOI is 1.5 times higher than required debt payments and is a fairly strong ratio.

Lenders typically look for a DSCR of at least 1.25 or higher. A DSCR below 1 suggests that the property’s cash flow is insufficient to cover its debt obligations, making it more challenging to refinance.

Financing your Buy-to-Let Property

Understanding and managing DSCR ratios is crucial for landlords who are looking to refinance their properties.

Not only should they work out their debt service coverage ratio accurately, but they also must make sure that the loan value is correct; that the property type is okay, and that the ownership structure is suitable for the lender to agree terms.

Sometimes, in a more complex holding company with a tiered limited company structure or even a Trust it can become extremely difficult to secure lending.

Specialist Buy-to-Let Brokers

Given the challenges in the sector for landlords – big and small – it is important to deal with a broker that has significant knowledge and experience of the market and has access to the best buy-to-let products. This area of mortgage and commercial broking is now a very specialist area.

We have a number of specialist buy-to-let brokers, who can navigate their way around the market and make sure we get the right deal for you.

But we can also help discuss options for repurposing a property or changing its use to increase the potential yield. This does obviously come with risk and additional costs in terms of architects, planning consultants, solicitors, and might require a separate finance product but can also provide a higher yielding asset and therefore greater revenue in the long run, as well as increased capital growth.

Current DSCR Standards in Lending

In recent years, lenders have tightened their DSCR requirements, but we are also seeing lenders front loading their product fee by increasing it from maybe two to five percent of the overall debt, but that enables them to reduce the overall interest to be paid on the capital, which means that the DSCR, is lower and makes the deal more affordable for the borrower.

Landlords Moving a portfolio from personal ownership to limited company

A number of landlords want to change their properties from personal ownership to limited company, which can offer significant tax benefits.

If you are considering this please contact your tax advisor or ask us for a contact for tax advice.

In relatively simple terms landlords that hold property in their name pay tax on all the rent they receive and then claim back a tax credit of 20% on mortgage interest costs.

Whereas for property that has been invested in via a limited company, the mortgage interest remained fully tax deductible. For this reason, we have helped many landlords to incorporate to a LLP partnership.

But, like every investment decision there are pros and cons with incorporation though, including but not limited to tax implications.

Working with a Commercial Finance Broker

To successfully navigate the growing complexities of DSCR in refinancing across a portfolio, it is imperative that landlords understand how DSCR impacts loan approvals and lender’s refinancing terms.

By effectively managing cash flow, rental income, and operating expenses, landlords can improve their DSCR ratios and secure favourable refinancing options.

In challenging market conditions, staying informed about changing DSCR requirements and seeking professional guidance from specialist buy-to-let finance brokers can help landlords overcome challenges and secure the most favourable deals available.