Saturday, January 9, 2016

Adding back Rent in the Debt Service Coverage Ratio

Often, the building where a business operates is owned separately from the business, itself.  The company-owner will typically own the building individually or through an LLC and lease it to the business.
In such an instance, the rent paid to company-owners (either directly or via LLC or other organization) is typically added back to the numerator of the debt service coverage ratio, while the debt service on the property is included in the denominator.

The cash flows of the company are effectively paying the debt service on the property, regardless of the paper trail.  To perform a full and proper debt service coverage analysis, you include the debt service on the mortgage in the denominator and, correspondingly, add back related rent to the numerator.  (Remember, if you include either rent in the numerator or mortgage debt service in the denominator, then you must include the other as well.)

Sometimes it is only appropriate to add back a portion of the total rent:

Example 1: If the total rent is comprised of rents for various properties, you will only add back the rent portion for the properties also owned by the owner of the company, since only that portion is included as debt service.

Example 2: The owner may effectively be distributing income to himself from the company through excessive rent.  If the rent paid by the company is significantly more than the debt service for the given property, then it may be appropriate to add back only the amount of rent necessary for debt service for the property.

Example 3: If a portion of the rent includes cash expenses such as taxes or insurance, then the amounts of each of these expenses should not be added back.  Do not add back rent unless you obtain a financial statement or lease or verify that the rent added back does not include such expenses.

Note also that you should add back rent paid to owners and consider the corresponding debt service even if the loan is from a different bank.  You also add back rent when the company had been renting but is now buying a facility.

1 comment:

  1. It is important to understand the reasoning behind rent add-backs. Rent is added back in order to allow for a combined debt service coverage ratio, which presents the full picture. Rent is also added back to allow the debt service coverage ratio to be compared (apples-to-apples) to that of another business where the business owns the building directly.

    Because of the desire for apples-to-apples comparisons, some banks may also choose to add back rent that is paid to third parties. In this case, the rent expense is added back to both the numerator and the denominator of the ratio. Note that this adjustment causes the debt service coverage ratio to be closer to 1.00x that it would have been otherwise. For a ratio above 1.00x, this adjustment causes the ratio to be lower or more conservative than it would have been without these add-backs. However, when the ratio is below 1.00x, this adjustment causes the debt service coverage ratio to be higher or less conservative than it would have been otherwise.

    Ken Pirok