Welcome back to another Deep Dive. Today I want
to start by asking you a question that might
feel a little bit invasive. I want to ask about
your pulse. We're getting physical right out
of the gate today. Metaphorically physical, yeah.
I want you to imagine a patient lying on a table
in a hospital. You're the doctor. You're standing
over them, looking at that monitor, you know,
the one with the squiggly green line and the
constant beeping sound. The vital signs monitor.
Exactly. That monitor tells you everything. It
tells you if the patient is, you know, resting
comfortably, if they're struggling for breath
or if they're essentially ready to get up, rip
out the IVs and go run a marathon. Right. Now.
Take that image, that whole life or death monitoring
thing, and map it onto your business or maybe
your real estate portfolio or honestly even just
your personal checking account. We're looking
for the financial heartbeat, the financial EKG.
We are. massive stack of research we went through
for this deep dive, and we have a lot of it today,
everything from banking guidelines to these fascinating
S &P case studies from the financial crisis,
it turns out that heartbeat isn't a squiggly
line. It isn't some vague feeling of, yeah, I
think we're doing okay. It's a number, a single
ruthless number. It's the DSCR, the dead service
coverage ratio. Which I have to say has got to
be one of the driest, most... most boring sounding
names in the history of finance. Debt service
coverage ratio. It does sound like homework.
It sounds like something you scroll past in the
terms and conditions without reading. You know,
it sounds like the kind of thing that makes your
eyes glaze over before you even finish saying
the words. It does sound dry. I'll give you that.
It sounds like compliance paperwork. But I would
argue, and I mean, the source material supports
this emphatically, that it is the single most
important metric for survival. Period. For survival.
It is the difference between a business that
owns its future and a business that is slowly,
quietly being repossessed by the bank. Survival.
That's a really big word. We usually talk about
things like profitability or, you know, growth.
But you're talking about sheer existence. I am
using that word deliberately. Because you can
have great ideas. You can have amazing marketing.
You can have a beautiful storefront and customers
lining up around the block. But if this one number,
this DSCR, is wrong, you are. dead you just you
just don't know it yet it measures one thing
and one thing only can you generate enough actual
cash to pay what you owe so okay our mission
today is to take this dry acronym and turn it
into something you can actually use we're going
to rip apart the dictionary definition and really
look at how banks use this number to decide your
fate we're going to look at the hidden traps
and there are specifically some tax traps in
here that honestly blew my mind that can bankrupt
you even if you think you're profitable and we
have a really fascinating detective story right
in the middle of this involving the 2008 financial
crisis, which shows what happens when you ignore
the nuance of this number. It effectively shows
how you can drown in a river that is on average
only two feet deep. I love that analogy. OK,
so buckle up. We are checking the pulse. Let's
start with the basics. We kind of need to do
a little anatomy lesson on the ratio itself.
The formula. The formula, the source material
lays it out and it looks simple enough on paper.
DSCR equals net operating income divided by total
debt service. Numerator and denominator, top
and bottom, simple fraction. Let's start with
the top half, the numerator. Net operating income
or NOI. Now, I feel like I know what income is.
You know, money comes in. I put it in the bank.
But net operating income feels like it has some
strings attached. It feels like an accountant's
term. It has very specific strings. And this
is where people get tripped up immediately. Net
operating income is, at its core, your gross
revenue minus your operating expenses. Okay.
Revenue minus expenses. I mean, that just sounds
like profit to me. Well, hold on. It really depends
on how you define expense. This is the crucial
distinction. When you are calculating NOI for
the purpose of this ratio, you are trying to
figure out the raw efficiency of the business
itself. The machine. Yes. You want to know how
the operation is performing completely independent
of how you paid for it or how the taxman treats
it. So we're looking for the purity of the business
model. Exactly. So think about what you normally
subtract from your bank account. You pay the
electric bill. Right. You pay the staff. You
pay for raw materials. You pay for insurance.
Those are all operating expenses. They are required
to keep the doors open, to keep the lights on.
So those get subtracted. Okay, that makes perfect
sense. Those are the costs of doing business.
But, and this is the big but, there are things
you don't subtract. And the big one, the one
that confuses absolutely everyone, is financing
costs. You do not subtract the interest on your
loans. Wait, let's pause right there. Because
if I have a loan, I have to pay the interest.
If I don't pay the interest, the bank takes my
business. Why on earth wouldn't I count that
as an expense? It feels like a very real expense
to me. It is a real expense. But remember, the
goal of the DSCR, the DSCR is a test to see if
you can afford the financing. You can't subtract
the interest to find out if you can afford the
interest. It's circular logic. It's like asking,
how much money do I have left after I spend all
my money? We need to know how much cash the machine
spits out before the bank takes its cut. Okay,
I think I see where you're going. It's like checking
the horsepower of a car engine. That's a perfect
analogy. Go on. You want to know how powerful
the engine is? That's the NOI. It doesn't matter
if you bought the car with cash or if you financed
it with some terrible high -interest loan. The
engine has the same horsepower regardless of
the financing. Precisely. The engine doesn't
care about your loan terms. So, we exclude interest
from the expenses to see the raw power. We also
exclude personal income taxes of the owners.
And here's another big one that throws people
off. We exclude capital expenditures and depreciation.
Depreciation. Yeah, let's stick on this for a
second. Because in the world of accounting, depreciation
is a massive deal. I buy a piece of machinery
for a million dollars or I buy an apartment building
and my accountant tells me I can write off a
chunk of that value every year as an expense.
It lowers my taxes. But you're saying for this
ratio, we just we ignore it. We ignore it completely.
We actually add it back in if it's been taken
out. Why? I mean, if my building is getting older,
the machine is wearing out, isn't that a real
cost? It is a cost in an accounting sense. It's
an allocation of a past cost over time. But DSCR
is a cash flow metric. It's not an accounting
trick. It's a reality check. When you claim depreciation
on your taxes, do you write a check to the Department
of Depreciation? No. No, of course not. I don't
send money anywhere. It's just a line on a tax
form. Exactly. It is a paper loss. No cash leaves
your bank account. The money is still there.
So since the bank wants to know how much cash
you have available to pay them, they add that
depreciation back in. They want to see the real,
tangible cash. So we're stripping away all the
accounting fiction. We aren't interested in taxable
income or what the tax form says. We are interested
in the raw, bloody cash flow that is sitting
in the register at the end of the day. Vivid,
but yes, that is the numerator. The NOI, the
cash generating power of the asset. OK, that's
the top. Now let's look at the denominator, the
bottom of the fraction, total debt service. Now,
usually when I hear service, I think of getting
my car fixed. But in finance, debt service just
means the bill. It is the bill, but it's the
whole bill. And this is where the symmetry with
the numerator gets really interesting. Remember
how we ignored interest in the top part? Right.
We kicked it out to see the raw power of the
engine. Well, we put it back in here on the bottom.
Total debt service includes your interest payments.
It includes any lease payments you might have.
And this is the critical part. It includes your
principal repayment. OK, so this is just the
total monthly check I write to the lender. Supple
enough. Correct. But there is a nuance here that
the sources point out, and it's really important.
We are including principal repayment as a cost
here. Which feels normal to me as a payer. I
have to pay it. It costs me money. It feels normal
to you. But to an accountant, that's weird. Because
typically, paying down principal isn't an expense
on a profit and loss statement. It's just moving
money from one pocket to another. How so? Well,
you're taking cash, which is an asset, and you're
using it to reduce a liability, your loan. The
net effect on your wealth, your net worth, is
zero. You're just... Changing its form. Right.
If I pay off $1 ,000 of my mortgage, I own $1
,000 more of the house. I'm basically paying
myself in a way. I'm increasing my net worth.
Exactly. That's the balance sheet view. But a
lender, a lender does not care about your net
worth on paper. They care about your liquidity.
Even if you are paying yourself in equity, that
cash has left the building. You cannot use that
cash to buy inventory. You cannot use that cash
to pay salaries. It is gone. It's no longer liquid.
That is a really, really critical shift in mindset.
We aren't looking at, am I getting richer? We're
asking, will I run out of cash this month? Correct.
It is a liquidity test, not a profitability test
or a wealth test. If you can't pay the principal,
you default. It doesn't matter if your equity
is going up on paper. If the cash isn't there
to make the payment, the game is over. So we
have the theory, NOI on top, that's the raw cash
engine, and total debt service on the bottom,
the whole bill. Let's ground this. The source
material gives us a character. Let's call him
Mr. Jones. Good old Mr. Jones. The everyman of
financial case studies. He's always buying a
duplex. So Mr. Jones decides to become a real
estate mogul. He buys a duplex. He rents it out.
He collects the rent. He pays the plumber. He
pays the insurance. He pays the property tax.
After all those operating expenses, he is left
with his net operating income. His NOI. The source
says his NOI is $36 ,000 a year. Okay, so that's
$3 ,000 a month of pure cash flow generated by
the building. That's his raw engine power. Now
he looks at his mortgage. He has to pay the bank
principal and interest. His total annual debt
service is $30 ,000. $2 ,500 a month. So we do
the math. $36 ,000 of income divided by $30 ,000
of debt. What do we get? We get 1 .2. So Mr.
Jones has a DSCR of 1 .2. Now, put that in plain
English for me. What does 1 .2 actually mean
for his life? What does it feel like? It means
he has a cushion. Specifically, it means for
every $1 he has to pay the bank, his property
is generating $1 .20. So he has 20 % more cash
coming in than he needs to send out. He pays
the bank the $30 ,000, and he still has $6 ,000
sitting in his account at the end of the year.
That's his breathing room. It's his margin for
error. If a tenant moves out for a month and
he loses some rent, or if the roof springs a
leak, or if insurance premiums go up unexpectedly,
he has that $6 ,000 buffer before he has to start
digging into his own personal pocket. And that
brings us perfectly to the next section, the
magic numbers. Because 1 .2 sounds good, but
is it good enough? That is the million -dollar
question, or perhaps the multimillion -dollar
loan question, depending on the deal. The sources
draw a very, very hard line in the sand at the
number 1 .0. 1 .0 is the break -even point. It
is the absolute edge of the cliff. If my DSCR
is exactly 1 .0, that means my income is exactly
equal to my debt, $30 ,000 in, $30 ,000 out.
You are treading water, and the water is right
at your lower lip. You aren't drowning, but you
are not moving. You have zero profit. But more
importantly, you have zero resilience. Right.
Because if anything goes wrong, even a tiny bit,
if the ratio drops to 0 .99... You are underwater.
You are drowning. Let's play out a scenario where
the ratio is, say, 0 .8. What does that life
look like for the owner? A DSCR of 0 .8 means
your property is only generating 80 cents for
every dollar of debt you owe. So you have a bill
in your hand for $1. The business gives you 80
cents. You're holding the bill. Where does the
other 20 cents come from? It has to come from
me. From somewhere else. Comes from your personal
savings. It comes from your salary as a dentist
or a teacher or whatever your day job is. It
comes from your kid's college fund. Every single
month you are writing a personal check to subsidize
this investment. You are actively bleeding money.
This is what they mean by cash flow negative.
It's a very polite clinical way of saying money
pit. So obviously banks hate anything below 1
.0. But do they accept 1 .0? If I walk into a
bank and say, hey, look, this deal breaks even
perfectly. Will they give me the loan? Almost
certainly not. No. Because bankers are professional
pessimists. Their job is to imagine everything
that can go wrong. Right. They know that the
world is chaotic. They know that HVAC systems
die two days after the warranty expires. They
know that good tenants lose their jobs. If you
start at 1 .0, the first distinct breeze will
blow you right over the cliff. They want a buffer,
a cushion. They demand a buffer. In commercial
real estate, the magic number is typically around
1 .25. So they want the income to be 125 % of
the debt. Right. They want a 25 % margin of safety.
If you walk in with a deal that's a 1 .05 or
a 1 .1, they'll likely show you the door. Or...
They will negotiate. How do they negotiate that?
Do they ask you to go back and increase the rent
on the property? They might suggest that, but
usually they attack the denominator, the part
they control. They say, we can't lend you this
much money because the payments are too high
for the income. So they lower the loan amount.
If you borrow less, your monthly payment goes
down. If the denominator of the fraction goes
down. The ratio goes up. So they force you to
put in a bigger down payment to make the math
work for them. That makes perfect sense. They
manipulate the loan amount until the ratio hits
their comfort zone. It protects them. Exactly.
And you, the listener, you need to understand
that this isn't just a hurdle you jumped over
once at the beginning to get the money. This
number. It haunts you. What do you mean by that?
The sources talk about loan covenants. These
are process rules written into the fine print
of the contract. A bank might put a clause in
your mortgage that says you must maintain a DSCR
of at least 1 .20 at all times for the life of
this loan. And if my rents dip for a few months
and I drop to 1 .15? You are in technical default.
Wait, seriously? Even if I make the payment,
let's say I write the check for the full amount
on time, the check clears, but my income drops
slightly, so my ratio is 1 .15. The bank can
still call the loan. Yes. Technically, you have
broken the promise. You have become a riskier
borrower than the one they agreed to lend to.
Now, usually they won't foreclose immediately.
Banks don't want to own real estate. It's a hassle.
Right. But they can use that default to force
you to restructure. They can raise your interest
rate. They can demand you put more cash in a
reserve account. They can seize control. That
is terrifying. It's like getting a speeding ticket
even though you didn't crash the car. It's risk
management. They don't want to wait for the crash.
They want to intervene when you start swerving.
That's why understanding this number is so critical.
It's not just about getting the loan. It's about
keeping the loan. Now, does this apply to everyone?
Or is this just for, you know, big corporations
and real estate moguls? The math applies to everyone,
but the context changes a little. In corporate
finance, for instance, they use it to verify
if a company can handle a big bond issue. They
look at something called sinking funds. Sinking
funds? That sounds ominous. Like a ship going
down? It's actually a safety mechanism. It's
the opposite. It's money that is set aside, sunk.
into a separate account, specifically to pay
off the principal of a bond when it matures in,
say, 10 or 20 years. Oh, OK. The DSCR calculation
for a corporation will include those sinking
fund contributions to make sure the company is
actually saving up to pay the big bill at the
end. And for personal finance, does this matter
for me if I'm just buying a house to live in?
Absolutely. 100%. If you go to get a mortgage
or a car loan or a personal loan, the loan officer
is doing a version of this math. They might call
it debt to income ratio, which is kind of the
inverse, but the logic is identical. Right. They
look at your pay stub, that's your NOI, and your
current debts, your student loans, your credit
cards, that's your debt service. If the ratio
is too tight, you get the application denied
letter. There was one other term in the source
material that caught my eye, DSRA. The debt service
reserve account. Ah, yes. This is big in project
finance. So think massive infrastructure. Building
a toll road. Building a power plant. A wind farm.
Okay. Big long -term stuff. Very big stuff. Let's
say you build a toll road. Most months, traffic
is great, predictable. But maybe one month there's
a massive blizzard and nobody drives for two
weeks. Your revenue tanks. Your DSCR for that
period drops way below 1 .0. You can't pay the
debt. Right. But you can't just foreclose on
a toll road or shut down a city's power plant
easily. So the lenders require a DSRA. It's a
literal bucket of cash, usually six months to
a year of bet payments, just sitting in a locked
account. An emergency fund. It's an emergency
fund, but it's mandated and controlled by the
bank. If you have a bad month, you dip into the
bucket to make the payment. It artificially fixes
the ratio for that month and keeps the project
from going bust over a temporary glitch. It smooths
out the bumps. Exactly. So we've established
that the DSCR is a survival metric. We know the
benchmarks. But benchmarks are just averages.
And averages. Averages can be dangerous liars.
They can be profoundly misleading. This brings
us to the detective work section of our deep
dive. The sources included a really fascinating
case study from the 2008 financial crisis involving
Standard & Poor's, S &P, and Bank of America.
This is a classic, classic example of why you
can't just look at the top line number and call
it a day. So set the scene for us. It's June
2008. Which, if you recall, is right as the financial
crisis is starting to rumble. The tremors are
really starting. Bear Stearns has already collapsed
a few months earlier. The housing market is cracking
wide open. There's a lot of fear in the air.
And in the middle of all this, S &P, the rating
agency, issues a press release. They are downgrading
the credit ratings on a pool of commercial mortgage
certificates from Bank of America. Specifically,
it was the 2005 one series, a pool of loans made
a few years earlier. And the reason they give
is credit deterioration. Now, usually that sounds
vague and corporate, but they get very specific.
They say that out of a pool of 135 loans, eight
specific loans had dropped below a DSCR of 1
.0x. Eight loans out of 135. So that's roughly
6 % of the pool. And because of those eight loans,
just 6 % of the total, they downgraded the certificates
that were backed by the entire pool. Now, here's
where the detective work comes in. The sources
break down the data on these bad apples. Right.
And this highlights a key point for anyone analyzing
anything. It is not enough to just know the current
DSCR. You need to know the rate of deterioration,
the trajectory. How fast is the patient crashing?
Exactly. Is it a slow decline or a nosedive?
S &P reported that these eight loans, which were
underwater with a DSCR below 1 .0, had an average
balance of about $10 .1 million. But here's the
kicker. Their DSCR had declined by an average
of 38 % since the loans were first issued. Wow.
38%. So they didn't just drift down, they plummeted.
That's a catastrophic drop. A 30 % drop in income
coverage is massive. That tells an analyst that
something is fundamentally, structurally wrong
with those properties or their management. They
are hemorrhaging cash. So you have these eight
disasters, the 6 % of the portfolio that's on
fire. But here is the twist. And this is what
I call the paradox of averages. The source asks
a really obvious question. If eight loans are
failing, what does the rest of the pool look
like? What is the DSCR for all 135 loans combined?
And this is where it gets so fascinating and,
frankly, so counterintuitive. The weighted average
DSCR for the entire pool was 1 .76x. 1 .76. That's
great. I mean, that's way, way above the 1 .25
safety zone we were just talking about. That
sounds incredibly healthy. It is. It's a fantastic
number on its own, but it gets even stranger.
The original weighted average for the pool back
in 2005 when those eight loans were presumably
healthy was 1 .666. Wait, wait, let me get this
straight. The pool. on average, got healthier.
Yes. The weighted average DSCR actually improved
from 1 .66 to 1 .76 over those few years. How
is that even possible? You have 6 % of the pool
collapsing, dropping 38 % in coverage, yet the
overall average goes up. That doesn't make any
sense. This is the danger of averages. It's a
perfect illustration. While those eight specific
loans were rotting from the inside out, the other
127 loans were likely doing quite well. Maybe
the owners of those properties were paying down
their principal aggressively, which lowers their
debt service. Maybe their rents went up. Since
the calculation is weighted by loan size, the
success of the healthy majority completely masked
the catastrophic failure of the minority. That
is such a crucial lesson. If you just looked
at the headline number, portfolio DSCR improves
to 1 .76, you'd think everything was perfect.
You'd think, wow, what a solid investment. I
should buy more. And you would be completely
missing the rot in the foundation. You'd miss
the fact that over $80 million worth of loans,
eight loans at around $10 million each, were
on the verge of default. It's like the Titanic.
Imagine you calculate the average dryness of
the passengers on the Titanic as it's sinking.
Most of the people are still on the upper deck,
sipping champagne, you know, waiting for the
lifeboats. They are perfectly dry. A few hundred
people in steerage are already underwater. But
if you average it out across everyone, the report
says status, mostly dry. That is a darker way
to put it. But yes, it's a perfect analogy. The
average depth of the water on the ship might
be low. But for the people in the steerage, that
average is meaningless. They're drowning. So
for you listening, the takeaway here is don't
just trust the top line number. You have to dig
into the distribution. You have to look at the
outliers. Absolutely. A high average DSCR doesn't
guarantee safety if there is a concentrated pocket
of extreme risk. And conversely, as we said,
a DSCR below 1 .0 doesn't guarantee default.
But it is a blinking red light that demands your
immediate attention. You have to look at the
loan level data. OK, speaking of looking closer,
we need to move to the final section of our dive.
And I'm going to warn you now, this is the advanced
class. This is the double black diamond run of
financial metrics for sure. We are going to talk
about taxes and specifically a fundamental flaw
in the standard DSCR calculation that, according
to our sources, leads people to think they are
safe when they are actually quietly going broke.
The pre -tax provision method. It sounds incredibly
intimidating. but the concept starts with a simple
question how does the irs the tax authority treat
your debt payments and the answer is inconsistently
very inconsistently okay so let's start with
the easy part we know that interest is tax deductible
right if you run a business Interest is an expense.
You subtract it from your income before you calculate
your taxes. Right. So if you earn a dollar and
you pay a dollar of interest, you have zero profit
and you pay zero tax. You pay the interest with
pre -tax dollars. Very efficient. But what about
principal? Principal is not tax deductible. Repeat
that for the people on the back. That seems really
important. You cannot deduct principal repayment.
You have to pay principal with after -tax dollars.
Okay, I want to make sure I really, really get
this. Let's say I have a lemonade stand. I borrowed
money to build the stand. This year, I owe the
bank $1 in principal. Okay. You owe $1. I sell
enough lemonade to make exactly $1 of profit.
I take that dollar, and I hand it to the banker
to pay the principal. We're good, right? I'm
all square. No. You... or in jail, or at least
you're in very deep trouble with the IRS. Why?
I made a dollar. I paid a dollar. I have nothing
left. Because you made $1 of profit. The IRS
wants its cut of that profit. Let's say the tax
rate is 35%. The IRS wants 35 cents from you.
But I gave the dollar to the banker. I don't
have it anymore. The IRS does not care. They
don't care what you did with the money. You earned
the profit. You owe the tax. The fact that you
used the cash to pay off a loan is your problem,
not theirs. So in order to pay the banker that
$1, I actually needed to earn more than a dollar.
Exactly. You needed to earn enough to pay the
taxman and still have a full dollar left over
for the banker. This is the tax trap. Now, the
standard DSCR formula, the simple NOI divided
by debt, does it account for this? Generally,
no. It treats all cash flow as equal. It assumes
a dollar of cash is a dollar of cash. It forgets
that some of those dollars have a tax toll on
them before they can be spent on certain things.
This leads to the distinction the sources make
between EBITDA and EBITDA. These acronyms get
thrown around a lot. Yes. EBITDA earnings before
interest, taxes, depreciation, and amortization.
It's a classic metric. The sources say EBITDA
is great for measuring your ability to make interest
-only payments. Because interest is pre -tax,
so it matches up. Exactly. But if you have to
pay principal, which is post -tax, you should
be looking at EBITDA without the T for taxes.
Or, more accurately, you need a method that actually
accounts for the tax bite on the principal portion.
Enter the pre -tax provision method. Right. This
method tries to solve that exact problem by calculating
exactly how much pre -tax cash you need to set
aside or provide to meet all of your post -tax
outlays. And post -tax outlays being things like
principal payments, but also paying dividends
to shareholders or any capital expenditures that
you can't finance with new debt. Correct. Anything
you have to pay with clean after -tax money.
Okay. I want to walk through the logic of this
calculation because it's really clever. It involves
a comparison between your non -cash expenses
and your post -tax outlays. It's a balancing
act. On one side of the scale, you have your
non -cash expenses, and the big one is depreciation.
We talked about this earlier. Depreciation is
a beautiful thing for cash flow because it shields
your income from taxes. Right. You report a loss
on paper, the depreciation, but you keep the
cash. It's like a tax -free allowance from the
government. So depreciation gives me a bucket
of tax -free cash. Exactly. So scenario A. Let's
say your depreciation for the year is greater
than your principal payments. Okay, so my tax
shield is bigger than the thing I need to shield?
In this case, you are safe. You are in good shape.
You can use that cash, which was shielded from
taxes by the depreciation, to pay the principal.
You don't take an extra tax hit. The provision
is just the amount of the principal. One dollar
debt needs one dollar of cash. Simple. Then there's
scenario B, the ouch scenario, as the source
calls it. This is where your principal payments
are greater than your depreciation. You have
exhausted your tax shield. You used up all your
depreciation credits for the year, but you still
owe more principal to the bank. So that extra
amount of principal is exposed to taxes. It's
unprotected. It is naked. To pay that extra unprotected
principal, you must earn extra pre -tax income
to cover the principal plus the taxes on that
income. The sources give a really concrete example
of this. Can we run the numbers? Let's do it.
So imagine a company. They have post -tax outlays,
let's just call it, principal for simplicity
of $100 million. Okay, they owe the bank $100
million in principal this year, a big bill. But
their non -cash expenses, their depreciation
is only $50 million. So they have a $50 million
shield but a $100 million bill. There's a mismatch.
Right. So the first $50 million of the debt is
covered. It can be paid using that cash that
was shielded by the depreciation. No tax problem
there. But they still have another $50 million
of principal left to pay. And no depreciation
left to hide it from the IRS. Correct. So assuming
a 35 % tax rate, they can't just go out and earn
$50 million. If they earn $50 million, the IRS
would take 35 % of that, which is $17 .5 million.
That would leave them with only $32 .5 million.
Not enough. Big shortfall. So they have to gross
up that income. They have to aim higher. Yes.
The formula is the shortfall divided by, in parentheses,
1 minus the tax rate. So $50 million divided
by 1 minus 0 .35. So $50 million divided by 0
.65. Which comes out to... Roughly $77 million.
Wow. So to pay that final $50 million of debt,
they need to earn $77 million of pre -tax income.
$27 million goes to the IRS. $50 million goes
to the bank. That is huge. That is a $27 million
hidden cost that the standard DSCR formula doesn't
show you at all. Exactly. So let's add it all
up. To pay the full $100 million debt, they need
the original $50 million that was shielded plus
the $77 million they had to earn to cover the
taxable part. Total requirement, $127 million
of pre -tax cash. So if you were just using the
basic math, you'd look at the bill and think,
I need $100 million. But in reality, because
of the tax code, you need $127 million. And that
gap, that $27 million gap. is where companies
go bankrupt. They look at their standard DSCR,
they think they have enough coverage, but the
quarterly tax bill hits and suddenly the cash
drawer is completely empty. They miscalculated
reality. This is why the pre -tax provision method
matters so much. It reviews the true actual cash
cost of the debt. It answers the real question.
How much do I really need to earn to keep the
lights on and the bankers happy, considering
Uncle Sam always eats first? It effectively de
-risks the analysis. It's a much more conservative,
much more realistic view of solvency. It is.
And if you are out there analyzing a stock or
looking at a company's books and you see they
have massive principal repayments coming due
and very little depreciation on their books,
you need to be doing this math because the company
might be a lot closer to the edge than it looks.
Wow. OK, so we've gone from the basic pulse check
all the way to advanced tax surgery. Let's zoom
out and just summarize what we've learned today.
Well, we started with the basic definition. GSCR
is the sleep at night number. It's net operating
income divided by total debt service. And we
learned that the total debt part includes principal
because cash is king. It's all about liquidity.
And the income part excludes depreciation and
interest because we want to see the raw engine
power of the asset itself. Then we established
the benchmarks. 1 .0 is bear survival. Anything
less is a slow death by 1 ,000 cuts. 1 .25 is
the general comfort zone for commercial real
estate. But banks vary, and those loan covenants
can trigger a default even if you're still making
your payments. We looked at the S &P case study
from 2008. The huge lesson there was, beware
the average. A portfolio can look shiny and healthy
on the surface 1 .76x coverage while having a
cancerous tumor of bad loans, with a 38 % decline
growing right inside it. And finally, we just
tackled the pre -tax provision method. The critical
realization that paying back principal is much
harder than it looks because you have to pay
taxes on that money first unless you have enough
depreciation to shield it. So what does this
all mean for you listening? Why should you care
about this dry, academic -sounding ratio? I think
it comes down to reality testing. Whether you
are buying a rental property, analyzing a stock
for your portfolio, or running a small business,
this ratio strips away all the noise. Accounting
can be creative. Net income can be manipulated
with all sorts of tricks. But DSCR, it's raw
cash reality. Can you pay the bills or not? It's
the truth serum of finance. It really is. It
doesn't lie. Before we go, I have a thought I
want to throw at you. It stems from that S &P
surprise. Let's hear it. We saw how a portfolio
could improve its average health while specific
parts of it were rotting. That 6 % of loans that
were just collapsing. It makes me wonder. When
we look at the wider economy, are we making the
same mistake? We hear headlines all the time.
Average GDP is up or average unemployment is
down. But does that high level comforting average
high deep structural rot in specific sectors
or demographics? Are we looking at the shiny
average and missing the cracks in the foundation,
just like the investors in that 2008 mortgage
pool? That is a profound question. We often optimize
society for the average and completely ignore
the distribution. In that S &P pool, ignoring
the tail risk of those eight bad loans led to
a sudden downgrade. In the wider economy, ignoring
the pockets of distress because the average looks
fine usually leads to social and economic shocks
that nobody in charge seems to see coming. Something
to mull over the next time you see a headline
about record highs. Indeed. Always check the
denominator and the outliers. Words to live by.
Thanks for listening to this deep dive. We'll
catch you in the next one.