WEBVTT 00:00:00.000 --> 00:00:02.680 Welcome back to another Deep Dive. Today I want 00:00:02.680 --> 00:00:05.139 to start by asking you a question that might 00:00:05.139 --> 00:00:07.419 feel a little bit invasive. I want to ask about 00:00:07.419 --> 00:00:10.019 your pulse. We're getting physical right out 00:00:10.019 --> 00:00:12.199 of the gate today. Metaphorically physical, yeah. 00:00:12.500 --> 00:00:15.439 I want you to imagine a patient lying on a table 00:00:15.439 --> 00:00:18.969 in a hospital. You're the doctor. You're standing 00:00:18.969 --> 00:00:21.070 over them, looking at that monitor, you know, 00:00:21.089 --> 00:00:22.969 the one with the squiggly green line and the 00:00:22.969 --> 00:00:25.929 constant beeping sound. The vital signs monitor. 00:00:26.370 --> 00:00:29.230 Exactly. That monitor tells you everything. It 00:00:29.230 --> 00:00:31.070 tells you if the patient is, you know, resting 00:00:31.070 --> 00:00:32.929 comfortably, if they're struggling for breath 00:00:32.929 --> 00:00:36.170 or if they're essentially ready to get up, rip 00:00:36.170 --> 00:00:38.869 out the IVs and go run a marathon. Right. Now. 00:00:39.359 --> 00:00:42.060 Take that image, that whole life or death monitoring 00:00:42.060 --> 00:00:44.840 thing, and map it onto your business or maybe 00:00:44.840 --> 00:00:47.640 your real estate portfolio or honestly even just 00:00:47.640 --> 00:00:49.340 your personal checking account. We're looking 00:00:49.340 --> 00:00:52.299 for the financial heartbeat, the financial EKG. 00:00:52.460 --> 00:00:56.219 We are. massive stack of research we went through 00:00:56.219 --> 00:00:58.299 for this deep dive, and we have a lot of it today, 00:00:58.460 --> 00:01:01.740 everything from banking guidelines to these fascinating 00:01:01.740 --> 00:01:03.859 S &P case studies from the financial crisis, 00:01:04.079 --> 00:01:06.659 it turns out that heartbeat isn't a squiggly 00:01:06.659 --> 00:01:09.939 line. It isn't some vague feeling of, yeah, I 00:01:09.939 --> 00:01:12.760 think we're doing okay. It's a number, a single 00:01:12.760 --> 00:01:16.079 ruthless number. It's the DSCR, the dead service 00:01:16.079 --> 00:01:18.780 coverage ratio. Which I have to say has got to 00:01:18.780 --> 00:01:22.969 be one of the driest, most... most boring sounding 00:01:22.969 --> 00:01:26.409 names in the history of finance. Debt service 00:01:26.409 --> 00:01:28.689 coverage ratio. It does sound like homework. 00:01:28.890 --> 00:01:30.849 It sounds like something you scroll past in the 00:01:30.849 --> 00:01:32.969 terms and conditions without reading. You know, 00:01:32.969 --> 00:01:34.510 it sounds like the kind of thing that makes your 00:01:34.510 --> 00:01:36.450 eyes glaze over before you even finish saying 00:01:36.450 --> 00:01:38.329 the words. It does sound dry. I'll give you that. 00:01:38.390 --> 00:01:41.290 It sounds like compliance paperwork. But I would 00:01:41.290 --> 00:01:44.390 argue, and I mean, the source material supports 00:01:44.390 --> 00:01:47.730 this emphatically, that it is the single most 00:01:47.730 --> 00:01:51.409 important metric for survival. Period. For survival. 00:01:51.609 --> 00:01:53.030 It is the difference between a business that 00:01:53.030 --> 00:01:55.370 owns its future and a business that is slowly, 00:01:55.469 --> 00:01:58.409 quietly being repossessed by the bank. Survival. 00:01:58.450 --> 00:02:00.370 That's a really big word. We usually talk about 00:02:00.370 --> 00:02:02.930 things like profitability or, you know, growth. 00:02:03.090 --> 00:02:05.349 But you're talking about sheer existence. I am 00:02:05.349 --> 00:02:07.810 using that word deliberately. Because you can 00:02:07.810 --> 00:02:09.810 have great ideas. You can have amazing marketing. 00:02:10.050 --> 00:02:13.069 You can have a beautiful storefront and customers 00:02:13.069 --> 00:02:16.110 lining up around the block. But if this one number, 00:02:16.189 --> 00:02:21.330 this DSCR, is wrong, you are. dead you just you 00:02:21.330 --> 00:02:23.509 just don't know it yet it measures one thing 00:02:23.509 --> 00:02:26.289 and one thing only can you generate enough actual 00:02:26.289 --> 00:02:29.389 cash to pay what you owe so okay our mission 00:02:29.389 --> 00:02:31.689 today is to take this dry acronym and turn it 00:02:31.689 --> 00:02:33.610 into something you can actually use we're going 00:02:33.610 --> 00:02:36.530 to rip apart the dictionary definition and really 00:02:36.530 --> 00:02:39.949 look at how banks use this number to decide your 00:02:39.949 --> 00:02:41.870 fate we're going to look at the hidden traps 00:02:41.870 --> 00:02:44.590 and there are specifically some tax traps in 00:02:44.590 --> 00:02:46.669 here that honestly blew my mind that can bankrupt 00:02:46.669 --> 00:02:49.090 you even if you think you're profitable and we 00:02:49.199 --> 00:02:51.139 have a really fascinating detective story right 00:02:51.139 --> 00:02:53.699 in the middle of this involving the 2008 financial 00:02:53.699 --> 00:02:57.099 crisis, which shows what happens when you ignore 00:02:57.099 --> 00:03:00.479 the nuance of this number. It effectively shows 00:03:00.479 --> 00:03:03.439 how you can drown in a river that is on average 00:03:03.439 --> 00:03:06.280 only two feet deep. I love that analogy. OK, 00:03:06.379 --> 00:03:09.300 so buckle up. We are checking the pulse. Let's 00:03:09.300 --> 00:03:10.900 start with the basics. We kind of need to do 00:03:10.900 --> 00:03:12.680 a little anatomy lesson on the ratio itself. 00:03:12.780 --> 00:03:14.840 The formula. The formula, the source material 00:03:14.840 --> 00:03:17.060 lays it out and it looks simple enough on paper. 00:03:17.620 --> 00:03:21.780 DSCR equals net operating income divided by total 00:03:21.780 --> 00:03:23.979 debt service. Numerator and denominator, top 00:03:23.979 --> 00:03:26.060 and bottom, simple fraction. Let's start with 00:03:26.060 --> 00:03:28.479 the top half, the numerator. Net operating income 00:03:28.479 --> 00:03:32.930 or NOI. Now, I feel like I know what income is. 00:03:33.009 --> 00:03:34.650 You know, money comes in. I put it in the bank. 00:03:34.729 --> 00:03:37.210 But net operating income feels like it has some 00:03:37.210 --> 00:03:39.550 strings attached. It feels like an accountant's 00:03:39.550 --> 00:03:42.169 term. It has very specific strings. And this 00:03:42.169 --> 00:03:44.250 is where people get tripped up immediately. Net 00:03:44.250 --> 00:03:48.150 operating income is, at its core, your gross 00:03:48.150 --> 00:03:50.909 revenue minus your operating expenses. Okay. 00:03:51.330 --> 00:03:53.490 Revenue minus expenses. I mean, that just sounds 00:03:53.490 --> 00:03:56.830 like profit to me. Well, hold on. It really depends 00:03:56.830 --> 00:04:00.189 on how you define expense. This is the crucial 00:04:00.189 --> 00:04:03.909 distinction. When you are calculating NOI for 00:04:03.909 --> 00:04:06.090 the purpose of this ratio, you are trying to 00:04:06.090 --> 00:04:08.250 figure out the raw efficiency of the business 00:04:08.250 --> 00:04:11.689 itself. The machine. Yes. You want to know how 00:04:11.689 --> 00:04:14.169 the operation is performing completely independent 00:04:14.169 --> 00:04:16.790 of how you paid for it or how the taxman treats 00:04:16.790 --> 00:04:19.250 it. So we're looking for the purity of the business 00:04:19.250 --> 00:04:22.209 model. Exactly. So think about what you normally 00:04:22.209 --> 00:04:24.230 subtract from your bank account. You pay the 00:04:24.230 --> 00:04:26.470 electric bill. Right. You pay the staff. You 00:04:26.470 --> 00:04:28.310 pay for raw materials. You pay for insurance. 00:04:28.629 --> 00:04:31.550 Those are all operating expenses. They are required 00:04:31.550 --> 00:04:33.750 to keep the doors open, to keep the lights on. 00:04:34.110 --> 00:04:36.529 So those get subtracted. Okay, that makes perfect 00:04:36.529 --> 00:04:38.449 sense. Those are the costs of doing business. 00:04:38.730 --> 00:04:40.529 But, and this is the big but, there are things 00:04:40.529 --> 00:04:43.089 you don't subtract. And the big one, the one 00:04:43.089 --> 00:04:45.529 that confuses absolutely everyone, is financing 00:04:45.529 --> 00:04:48.750 costs. You do not subtract the interest on your 00:04:48.750 --> 00:04:52.290 loans. Wait, let's pause right there. Because 00:04:52.290 --> 00:04:54.209 if I have a loan, I have to pay the interest. 00:04:54.629 --> 00:04:57.050 If I don't pay the interest, the bank takes my 00:04:57.050 --> 00:04:59.810 business. Why on earth wouldn't I count that 00:04:59.810 --> 00:05:02.110 as an expense? It feels like a very real expense 00:05:02.110 --> 00:05:04.730 to me. It is a real expense. But remember, the 00:05:04.730 --> 00:05:08.209 goal of the DSCR, the DSCR is a test to see if 00:05:08.209 --> 00:05:11.029 you can afford the financing. You can't subtract 00:05:11.029 --> 00:05:13.790 the interest to find out if you can afford the 00:05:13.790 --> 00:05:16.930 interest. It's circular logic. It's like asking, 00:05:17.029 --> 00:05:19.509 how much money do I have left after I spend all 00:05:19.509 --> 00:05:22.230 my money? We need to know how much cash the machine 00:05:22.230 --> 00:05:24.810 spits out before the bank takes its cut. Okay, 00:05:24.850 --> 00:05:27.170 I think I see where you're going. It's like checking 00:05:27.170 --> 00:05:29.610 the horsepower of a car engine. That's a perfect 00:05:29.610 --> 00:05:31.810 analogy. Go on. You want to know how powerful 00:05:31.810 --> 00:05:34.389 the engine is? That's the NOI. It doesn't matter 00:05:34.389 --> 00:05:37.069 if you bought the car with cash or if you financed 00:05:37.069 --> 00:05:39.209 it with some terrible high -interest loan. The 00:05:39.209 --> 00:05:41.709 engine has the same horsepower regardless of 00:05:41.709 --> 00:05:44.490 the financing. Precisely. The engine doesn't 00:05:44.490 --> 00:05:47.980 care about your loan terms. So, we exclude interest 00:05:47.980 --> 00:05:51.139 from the expenses to see the raw power. We also 00:05:51.139 --> 00:05:53.620 exclude personal income taxes of the owners. 00:05:53.800 --> 00:05:55.740 And here's another big one that throws people 00:05:55.740 --> 00:06:01.040 off. We exclude capital expenditures and depreciation. 00:06:01.490 --> 00:06:03.110 Depreciation. Yeah, let's stick on this for a 00:06:03.110 --> 00:06:05.810 second. Because in the world of accounting, depreciation 00:06:05.810 --> 00:06:08.589 is a massive deal. I buy a piece of machinery 00:06:08.589 --> 00:06:10.629 for a million dollars or I buy an apartment building 00:06:10.629 --> 00:06:13.310 and my accountant tells me I can write off a 00:06:13.310 --> 00:06:15.389 chunk of that value every year as an expense. 00:06:15.509 --> 00:06:18.290 It lowers my taxes. But you're saying for this 00:06:18.290 --> 00:06:21.230 ratio, we just we ignore it. We ignore it completely. 00:06:21.720 --> 00:06:23.420 We actually add it back in if it's been taken 00:06:23.420 --> 00:06:26.480 out. Why? I mean, if my building is getting older, 00:06:26.600 --> 00:06:28.240 the machine is wearing out, isn't that a real 00:06:28.240 --> 00:06:30.759 cost? It is a cost in an accounting sense. It's 00:06:30.759 --> 00:06:33.800 an allocation of a past cost over time. But DSCR 00:06:33.800 --> 00:06:36.980 is a cash flow metric. It's not an accounting 00:06:36.980 --> 00:06:40.040 trick. It's a reality check. When you claim depreciation 00:06:40.040 --> 00:06:42.600 on your taxes, do you write a check to the Department 00:06:42.600 --> 00:06:45.060 of Depreciation? No. No, of course not. I don't 00:06:45.060 --> 00:06:47.560 send money anywhere. It's just a line on a tax 00:06:47.560 --> 00:06:51.389 form. Exactly. It is a paper loss. No cash leaves 00:06:51.389 --> 00:06:53.529 your bank account. The money is still there. 00:06:54.009 --> 00:06:56.069 So since the bank wants to know how much cash 00:06:56.069 --> 00:06:58.170 you have available to pay them, they add that 00:06:58.170 --> 00:07:00.730 depreciation back in. They want to see the real, 00:07:00.769 --> 00:07:03.689 tangible cash. So we're stripping away all the 00:07:03.689 --> 00:07:06.629 accounting fiction. We aren't interested in taxable 00:07:06.629 --> 00:07:09.970 income or what the tax form says. We are interested 00:07:09.970 --> 00:07:12.810 in the raw, bloody cash flow that is sitting 00:07:12.810 --> 00:07:14.870 in the register at the end of the day. Vivid, 00:07:14.910 --> 00:07:19.029 but yes, that is the numerator. The NOI, the 00:07:19.029 --> 00:07:21.589 cash generating power of the asset. OK, that's 00:07:21.589 --> 00:07:23.250 the top. Now let's look at the denominator, the 00:07:23.250 --> 00:07:25.990 bottom of the fraction, total debt service. Now, 00:07:26.009 --> 00:07:28.089 usually when I hear service, I think of getting 00:07:28.089 --> 00:07:31.449 my car fixed. But in finance, debt service just 00:07:31.449 --> 00:07:34.709 means the bill. It is the bill, but it's the 00:07:34.709 --> 00:07:36.829 whole bill. And this is where the symmetry with 00:07:36.829 --> 00:07:38.569 the numerator gets really interesting. Remember 00:07:38.569 --> 00:07:40.810 how we ignored interest in the top part? Right. 00:07:40.970 --> 00:07:43.209 We kicked it out to see the raw power of the 00:07:43.209 --> 00:07:45.500 engine. Well, we put it back in here on the bottom. 00:07:45.740 --> 00:07:48.420 Total debt service includes your interest payments. 00:07:48.600 --> 00:07:50.819 It includes any lease payments you might have. 00:07:51.500 --> 00:07:54.540 And this is the critical part. It includes your 00:07:54.540 --> 00:07:56.500 principal repayment. OK, so this is just the 00:07:56.500 --> 00:07:59.600 total monthly check I write to the lender. Supple 00:07:59.600 --> 00:08:02.240 enough. Correct. But there is a nuance here that 00:08:02.240 --> 00:08:04.220 the sources point out, and it's really important. 00:08:04.379 --> 00:08:07.139 We are including principal repayment as a cost 00:08:07.139 --> 00:08:09.949 here. Which feels normal to me as a payer. I 00:08:09.949 --> 00:08:12.410 have to pay it. It costs me money. It feels normal 00:08:12.410 --> 00:08:15.730 to you. But to an accountant, that's weird. Because 00:08:15.730 --> 00:08:19.009 typically, paying down principal isn't an expense 00:08:19.009 --> 00:08:22.050 on a profit and loss statement. It's just moving 00:08:22.050 --> 00:08:25.009 money from one pocket to another. How so? Well, 00:08:25.089 --> 00:08:27.629 you're taking cash, which is an asset, and you're 00:08:27.629 --> 00:08:30.750 using it to reduce a liability, your loan. The 00:08:30.750 --> 00:08:33.190 net effect on your wealth, your net worth, is 00:08:33.190 --> 00:08:35.840 zero. You're just... Changing its form. Right. 00:08:35.899 --> 00:08:38.559 If I pay off $1 ,000 of my mortgage, I own $1 00:08:38.559 --> 00:08:41.240 ,000 more of the house. I'm basically paying 00:08:41.240 --> 00:08:43.700 myself in a way. I'm increasing my net worth. 00:08:44.299 --> 00:08:46.840 Exactly. That's the balance sheet view. But a 00:08:46.840 --> 00:08:49.759 lender, a lender does not care about your net 00:08:49.759 --> 00:08:51.879 worth on paper. They care about your liquidity. 00:08:52.240 --> 00:08:55.899 Even if you are paying yourself in equity, that 00:08:55.899 --> 00:08:59.100 cash has left the building. You cannot use that 00:08:59.100 --> 00:09:01.600 cash to buy inventory. You cannot use that cash 00:09:01.600 --> 00:09:04.779 to pay salaries. It is gone. It's no longer liquid. 00:09:04.960 --> 00:09:08.460 That is a really, really critical shift in mindset. 00:09:08.639 --> 00:09:11.100 We aren't looking at, am I getting richer? We're 00:09:11.100 --> 00:09:13.879 asking, will I run out of cash this month? Correct. 00:09:14.019 --> 00:09:16.659 It is a liquidity test, not a profitability test 00:09:16.659 --> 00:09:18.980 or a wealth test. If you can't pay the principal, 00:09:19.200 --> 00:09:21.299 you default. It doesn't matter if your equity 00:09:21.299 --> 00:09:23.460 is going up on paper. If the cash isn't there 00:09:23.460 --> 00:09:25.919 to make the payment, the game is over. So we 00:09:25.919 --> 00:09:28.620 have the theory, NOI on top, that's the raw cash 00:09:28.620 --> 00:09:30.899 engine, and total debt service on the bottom, 00:09:30.940 --> 00:09:33.409 the whole bill. Let's ground this. The source 00:09:33.409 --> 00:09:35.129 material gives us a character. Let's call him 00:09:35.129 --> 00:09:38.389 Mr. Jones. Good old Mr. Jones. The everyman of 00:09:38.389 --> 00:09:40.149 financial case studies. He's always buying a 00:09:40.149 --> 00:09:43.509 duplex. So Mr. Jones decides to become a real 00:09:43.509 --> 00:09:46.570 estate mogul. He buys a duplex. He rents it out. 00:09:46.649 --> 00:09:48.570 He collects the rent. He pays the plumber. He 00:09:48.570 --> 00:09:50.429 pays the insurance. He pays the property tax. 00:09:51.129 --> 00:09:53.789 After all those operating expenses, he is left 00:09:53.789 --> 00:09:56.889 with his net operating income. His NOI. The source 00:09:56.889 --> 00:10:01.370 says his NOI is $36 ,000 a year. Okay, so that's 00:10:01.370 --> 00:10:04.529 $3 ,000 a month of pure cash flow generated by 00:10:04.529 --> 00:10:07.669 the building. That's his raw engine power. Now 00:10:07.669 --> 00:10:09.809 he looks at his mortgage. He has to pay the bank 00:10:09.809 --> 00:10:12.710 principal and interest. His total annual debt 00:10:12.710 --> 00:10:16.850 service is $30 ,000. $2 ,500 a month. So we do 00:10:16.850 --> 00:10:20.250 the math. $36 ,000 of income divided by $30 ,000 00:10:20.250 --> 00:10:23.570 of debt. What do we get? We get 1 .2. So Mr. 00:10:23.669 --> 00:10:27.830 Jones has a DSCR of 1 .2. Now, put that in plain 00:10:27.830 --> 00:10:30.789 English for me. What does 1 .2 actually mean 00:10:30.789 --> 00:10:32.970 for his life? What does it feel like? It means 00:10:32.970 --> 00:10:35.470 he has a cushion. Specifically, it means for 00:10:35.470 --> 00:10:38.149 every $1 he has to pay the bank, his property 00:10:38.149 --> 00:10:41.789 is generating $1 .20. So he has 20 % more cash 00:10:41.789 --> 00:10:44.110 coming in than he needs to send out. He pays 00:10:44.110 --> 00:10:46.789 the bank the $30 ,000, and he still has $6 ,000 00:10:46.789 --> 00:10:48.610 sitting in his account at the end of the year. 00:10:48.710 --> 00:10:50.830 That's his breathing room. It's his margin for 00:10:50.830 --> 00:10:53.230 error. If a tenant moves out for a month and 00:10:53.230 --> 00:10:55.809 he loses some rent, or if the roof springs a 00:10:55.809 --> 00:10:57.990 leak, or if insurance premiums go up unexpectedly, 00:10:58.470 --> 00:11:01.610 he has that $6 ,000 buffer before he has to start 00:11:01.610 --> 00:11:03.470 digging into his own personal pocket. And that 00:11:03.470 --> 00:11:05.570 brings us perfectly to the next section, the 00:11:05.570 --> 00:11:09.629 magic numbers. Because 1 .2 sounds good, but 00:11:09.629 --> 00:11:11.710 is it good enough? That is the million -dollar 00:11:11.710 --> 00:11:13.509 question, or perhaps the multimillion -dollar 00:11:13.509 --> 00:11:15.789 loan question, depending on the deal. The sources 00:11:15.789 --> 00:11:19.250 draw a very, very hard line in the sand at the 00:11:19.250 --> 00:11:22.429 number 1 .0. 1 .0 is the break -even point. It 00:11:22.429 --> 00:11:24.909 is the absolute edge of the cliff. If my DSCR 00:11:24.909 --> 00:11:28.629 is exactly 1 .0, that means my income is exactly 00:11:28.629 --> 00:11:31.590 equal to my debt, $30 ,000 in, $30 ,000 out. 00:11:31.730 --> 00:11:34.350 You are treading water, and the water is right 00:11:34.350 --> 00:11:36.750 at your lower lip. You aren't drowning, but you 00:11:36.750 --> 00:11:39.990 are not moving. You have zero profit. But more 00:11:39.990 --> 00:11:42.649 importantly, you have zero resilience. Right. 00:11:43.120 --> 00:11:45.919 Because if anything goes wrong, even a tiny bit, 00:11:46.139 --> 00:11:49.840 if the ratio drops to 0 .99... You are underwater. 00:11:50.059 --> 00:11:52.600 You are drowning. Let's play out a scenario where 00:11:52.600 --> 00:11:55.419 the ratio is, say, 0 .8. What does that life 00:11:55.419 --> 00:11:59.460 look like for the owner? A DSCR of 0 .8 means 00:11:59.460 --> 00:12:02.500 your property is only generating 80 cents for 00:12:02.500 --> 00:12:05.240 every dollar of debt you owe. So you have a bill 00:12:05.240 --> 00:12:07.679 in your hand for $1. The business gives you 80 00:12:07.679 --> 00:12:10.000 cents. You're holding the bill. Where does the 00:12:10.000 --> 00:12:12.279 other 20 cents come from? It has to come from 00:12:12.279 --> 00:12:14.279 me. From somewhere else. Comes from your personal 00:12:14.279 --> 00:12:16.879 savings. It comes from your salary as a dentist 00:12:16.879 --> 00:12:19.340 or a teacher or whatever your day job is. It 00:12:19.340 --> 00:12:21.899 comes from your kid's college fund. Every single 00:12:21.899 --> 00:12:25.159 month you are writing a personal check to subsidize 00:12:25.159 --> 00:12:28.139 this investment. You are actively bleeding money. 00:12:28.360 --> 00:12:30.240 This is what they mean by cash flow negative. 00:12:30.419 --> 00:12:32.639 It's a very polite clinical way of saying money 00:12:32.639 --> 00:12:35.679 pit. So obviously banks hate anything below 1 00:12:35.679 --> 00:12:38.720 .0. But do they accept 1 .0? If I walk into a 00:12:38.720 --> 00:12:40.759 bank and say, hey, look, this deal breaks even 00:12:40.759 --> 00:12:43.029 perfectly. Will they give me the loan? Almost 00:12:43.029 --> 00:12:46.529 certainly not. No. Because bankers are professional 00:12:46.529 --> 00:12:49.669 pessimists. Their job is to imagine everything 00:12:49.669 --> 00:12:51.730 that can go wrong. Right. They know that the 00:12:51.730 --> 00:12:54.629 world is chaotic. They know that HVAC systems 00:12:54.629 --> 00:12:58.090 die two days after the warranty expires. They 00:12:58.090 --> 00:13:01.360 know that good tenants lose their jobs. If you 00:13:01.360 --> 00:13:04.200 start at 1 .0, the first distinct breeze will 00:13:04.200 --> 00:13:06.059 blow you right over the cliff. They want a buffer, 00:13:06.159 --> 00:13:08.299 a cushion. They demand a buffer. In commercial 00:13:08.299 --> 00:13:10.679 real estate, the magic number is typically around 00:13:10.679 --> 00:13:15.299 1 .25. So they want the income to be 125 % of 00:13:15.299 --> 00:13:17.779 the debt. Right. They want a 25 % margin of safety. 00:13:18.139 --> 00:13:21.100 If you walk in with a deal that's a 1 .05 or 00:13:21.100 --> 00:13:24.600 a 1 .1, they'll likely show you the door. Or... 00:13:24.970 --> 00:13:27.389 They will negotiate. How do they negotiate that? 00:13:27.429 --> 00:13:29.909 Do they ask you to go back and increase the rent 00:13:29.909 --> 00:13:32.549 on the property? They might suggest that, but 00:13:32.549 --> 00:13:34.789 usually they attack the denominator, the part 00:13:34.789 --> 00:13:36.990 they control. They say, we can't lend you this 00:13:36.990 --> 00:13:39.889 much money because the payments are too high 00:13:39.889 --> 00:13:41.730 for the income. So they lower the loan amount. 00:13:41.889 --> 00:13:44.230 If you borrow less, your monthly payment goes 00:13:44.230 --> 00:13:46.909 down. If the denominator of the fraction goes 00:13:46.909 --> 00:13:49.710 down. The ratio goes up. So they force you to 00:13:49.710 --> 00:13:52.009 put in a bigger down payment to make the math 00:13:52.009 --> 00:13:54.230 work for them. That makes perfect sense. They 00:13:54.230 --> 00:13:56.370 manipulate the loan amount until the ratio hits 00:13:56.370 --> 00:13:59.129 their comfort zone. It protects them. Exactly. 00:13:59.190 --> 00:14:01.730 And you, the listener, you need to understand 00:14:01.730 --> 00:14:03.809 that this isn't just a hurdle you jumped over 00:14:03.809 --> 00:14:06.110 once at the beginning to get the money. This 00:14:06.110 --> 00:14:09.059 number. It haunts you. What do you mean by that? 00:14:09.259 --> 00:14:10.980 The sources talk about loan covenants. These 00:14:10.980 --> 00:14:13.419 are process rules written into the fine print 00:14:13.419 --> 00:14:16.039 of the contract. A bank might put a clause in 00:14:16.039 --> 00:14:18.940 your mortgage that says you must maintain a DSCR 00:14:18.940 --> 00:14:22.700 of at least 1 .20 at all times for the life of 00:14:22.700 --> 00:14:24.919 this loan. And if my rents dip for a few months 00:14:24.919 --> 00:14:28.000 and I drop to 1 .15? You are in technical default. 00:14:28.259 --> 00:14:30.240 Wait, seriously? Even if I make the payment, 00:14:30.320 --> 00:14:32.059 let's say I write the check for the full amount 00:14:32.059 --> 00:14:34.980 on time, the check clears, but my income drops 00:14:34.980 --> 00:14:38.059 slightly, so my ratio is 1 .15. The bank can 00:14:38.059 --> 00:14:41.820 still call the loan. Yes. Technically, you have 00:14:41.820 --> 00:14:44.980 broken the promise. You have become a riskier 00:14:44.980 --> 00:14:47.500 borrower than the one they agreed to lend to. 00:14:47.659 --> 00:14:50.139 Now, usually they won't foreclose immediately. 00:14:50.440 --> 00:14:52.820 Banks don't want to own real estate. It's a hassle. 00:14:52.980 --> 00:14:56.340 Right. But they can use that default to force 00:14:56.340 --> 00:14:58.759 you to restructure. They can raise your interest 00:14:58.759 --> 00:15:01.559 rate. They can demand you put more cash in a 00:15:01.559 --> 00:15:04.299 reserve account. They can seize control. That 00:15:04.299 --> 00:15:06.759 is terrifying. It's like getting a speeding ticket 00:15:06.759 --> 00:15:08.779 even though you didn't crash the car. It's risk 00:15:08.779 --> 00:15:10.860 management. They don't want to wait for the crash. 00:15:11.039 --> 00:15:13.159 They want to intervene when you start swerving. 00:15:13.620 --> 00:15:15.840 That's why understanding this number is so critical. 00:15:16.039 --> 00:15:17.940 It's not just about getting the loan. It's about 00:15:17.940 --> 00:15:20.340 keeping the loan. Now, does this apply to everyone? 00:15:20.879 --> 00:15:22.940 Or is this just for, you know, big corporations 00:15:22.940 --> 00:15:25.799 and real estate moguls? The math applies to everyone, 00:15:25.960 --> 00:15:28.299 but the context changes a little. In corporate 00:15:28.299 --> 00:15:30.419 finance, for instance, they use it to verify 00:15:30.419 --> 00:15:33.139 if a company can handle a big bond issue. They 00:15:33.139 --> 00:15:35.379 look at something called sinking funds. Sinking 00:15:35.379 --> 00:15:37.799 funds? That sounds ominous. Like a ship going 00:15:37.799 --> 00:15:40.580 down? It's actually a safety mechanism. It's 00:15:40.580 --> 00:15:43.799 the opposite. It's money that is set aside, sunk. 00:15:44.279 --> 00:15:46.820 into a separate account, specifically to pay 00:15:46.820 --> 00:15:48.940 off the principal of a bond when it matures in, 00:15:49.019 --> 00:15:52.240 say, 10 or 20 years. Oh, OK. The DSCR calculation 00:15:52.240 --> 00:15:55.700 for a corporation will include those sinking 00:15:55.700 --> 00:15:57.980 fund contributions to make sure the company is 00:15:57.980 --> 00:16:00.340 actually saving up to pay the big bill at the 00:16:00.340 --> 00:16:02.519 end. And for personal finance, does this matter 00:16:02.519 --> 00:16:04.440 for me if I'm just buying a house to live in? 00:16:04.539 --> 00:16:07.320 Absolutely. 100%. If you go to get a mortgage 00:16:07.320 --> 00:16:10.100 or a car loan or a personal loan, the loan officer 00:16:10.100 --> 00:16:11.879 is doing a version of this math. They might call 00:16:11.879 --> 00:16:14.000 it debt to income ratio, which is kind of the 00:16:14.000 --> 00:16:16.600 inverse, but the logic is identical. Right. They 00:16:16.600 --> 00:16:19.279 look at your pay stub, that's your NOI, and your 00:16:19.279 --> 00:16:21.379 current debts, your student loans, your credit 00:16:21.379 --> 00:16:23.899 cards, that's your debt service. If the ratio 00:16:23.899 --> 00:16:25.840 is too tight, you get the application denied 00:16:25.840 --> 00:16:28.220 letter. There was one other term in the source 00:16:28.220 --> 00:16:31.600 material that caught my eye, DSRA. The debt service 00:16:31.600 --> 00:16:34.559 reserve account. Ah, yes. This is big in project 00:16:34.559 --> 00:16:37.460 finance. So think massive infrastructure. Building 00:16:37.460 --> 00:16:40.879 a toll road. Building a power plant. A wind farm. 00:16:41.100 --> 00:16:45.720 Okay. Big long -term stuff. Very big stuff. Let's 00:16:45.720 --> 00:16:48.460 say you build a toll road. Most months, traffic 00:16:48.460 --> 00:16:51.519 is great, predictable. But maybe one month there's 00:16:51.519 --> 00:16:53.480 a massive blizzard and nobody drives for two 00:16:53.480 --> 00:16:57.070 weeks. Your revenue tanks. Your DSCR for that 00:16:57.070 --> 00:17:00.049 period drops way below 1 .0. You can't pay the 00:17:00.049 --> 00:17:02.750 debt. Right. But you can't just foreclose on 00:17:02.750 --> 00:17:05.130 a toll road or shut down a city's power plant 00:17:05.130 --> 00:17:08.730 easily. So the lenders require a DSRA. It's a 00:17:08.730 --> 00:17:11.529 literal bucket of cash, usually six months to 00:17:11.529 --> 00:17:14.190 a year of bet payments, just sitting in a locked 00:17:14.190 --> 00:17:16.230 account. An emergency fund. It's an emergency 00:17:16.230 --> 00:17:18.549 fund, but it's mandated and controlled by the 00:17:18.549 --> 00:17:21.069 bank. If you have a bad month, you dip into the 00:17:21.069 --> 00:17:23.839 bucket to make the payment. It artificially fixes 00:17:23.839 --> 00:17:26.059 the ratio for that month and keeps the project 00:17:26.059 --> 00:17:28.660 from going bust over a temporary glitch. It smooths 00:17:28.660 --> 00:17:30.680 out the bumps. Exactly. So we've established 00:17:30.680 --> 00:17:33.400 that the DSCR is a survival metric. We know the 00:17:33.400 --> 00:17:35.779 benchmarks. But benchmarks are just averages. 00:17:36.079 --> 00:17:39.380 And averages. Averages can be dangerous liars. 00:17:39.480 --> 00:17:41.539 They can be profoundly misleading. This brings 00:17:41.539 --> 00:17:43.660 us to the detective work section of our deep 00:17:43.660 --> 00:17:46.099 dive. The sources included a really fascinating 00:17:46.099 --> 00:17:49.339 case study from the 2008 financial crisis involving 00:17:49.339 --> 00:17:52.200 Standard & Poor's, S &P, and Bank of America. 00:17:52.779 --> 00:17:55.180 This is a classic, classic example of why you 00:17:55.180 --> 00:17:56.759 can't just look at the top line number and call 00:17:56.759 --> 00:17:59.180 it a day. So set the scene for us. It's June 00:17:59.180 --> 00:18:03.079 2008. Which, if you recall, is right as the financial 00:18:03.079 --> 00:18:05.759 crisis is starting to rumble. The tremors are 00:18:05.759 --> 00:18:08.279 really starting. Bear Stearns has already collapsed 00:18:08.279 --> 00:18:10.980 a few months earlier. The housing market is cracking 00:18:10.980 --> 00:18:13.640 wide open. There's a lot of fear in the air. 00:18:14.039 --> 00:18:16.380 And in the middle of all this, S &P, the rating 00:18:16.380 --> 00:18:19.640 agency, issues a press release. They are downgrading 00:18:19.640 --> 00:18:21.799 the credit ratings on a pool of commercial mortgage 00:18:21.799 --> 00:18:24.359 certificates from Bank of America. Specifically, 00:18:24.579 --> 00:18:28.140 it was the 2005 one series, a pool of loans made 00:18:28.140 --> 00:18:30.019 a few years earlier. And the reason they give 00:18:30.019 --> 00:18:33.299 is credit deterioration. Now, usually that sounds 00:18:33.299 --> 00:18:35.160 vague and corporate, but they get very specific. 00:18:35.460 --> 00:18:39.619 They say that out of a pool of 135 loans, eight 00:18:39.619 --> 00:18:42.839 specific loans had dropped below a DSCR of 1 00:18:42.839 --> 00:18:46.420 .0x. Eight loans out of 135. So that's roughly 00:18:46.420 --> 00:18:49.680 6 % of the pool. And because of those eight loans, 00:18:49.900 --> 00:18:53.460 just 6 % of the total, they downgraded the certificates 00:18:53.460 --> 00:18:56.740 that were backed by the entire pool. Now, here's 00:18:56.740 --> 00:18:58.900 where the detective work comes in. The sources 00:18:58.900 --> 00:19:01.539 break down the data on these bad apples. Right. 00:19:01.849 --> 00:19:04.150 And this highlights a key point for anyone analyzing 00:19:04.150 --> 00:19:08.269 anything. It is not enough to just know the current 00:19:08.269 --> 00:19:11.670 DSCR. You need to know the rate of deterioration, 00:19:11.690 --> 00:19:14.690 the trajectory. How fast is the patient crashing? 00:19:14.950 --> 00:19:17.529 Exactly. Is it a slow decline or a nosedive? 00:19:17.910 --> 00:19:20.609 S &P reported that these eight loans, which were 00:19:20.609 --> 00:19:24.589 underwater with a DSCR below 1 .0, had an average 00:19:24.589 --> 00:19:28.059 balance of about $10 .1 million. But here's the 00:19:28.059 --> 00:19:30.559 kicker. Their DSCR had declined by an average 00:19:30.559 --> 00:19:33.319 of 38 % since the loans were first issued. Wow. 00:19:33.740 --> 00:19:36.200 38%. So they didn't just drift down, they plummeted. 00:19:36.200 --> 00:19:39.099 That's a catastrophic drop. A 30 % drop in income 00:19:39.099 --> 00:19:41.980 coverage is massive. That tells an analyst that 00:19:41.980 --> 00:19:44.200 something is fundamentally, structurally wrong 00:19:44.200 --> 00:19:46.660 with those properties or their management. They 00:19:46.660 --> 00:19:48.859 are hemorrhaging cash. So you have these eight 00:19:48.859 --> 00:19:52.059 disasters, the 6 % of the portfolio that's on 00:19:52.059 --> 00:19:55.500 fire. But here is the twist. And this is what 00:19:55.500 --> 00:19:58.519 I call the paradox of averages. The source asks 00:19:58.519 --> 00:20:01.119 a really obvious question. If eight loans are 00:20:01.119 --> 00:20:03.099 failing, what does the rest of the pool look 00:20:03.099 --> 00:20:07.940 like? What is the DSCR for all 135 loans combined? 00:20:08.299 --> 00:20:10.019 And this is where it gets so fascinating and, 00:20:10.059 --> 00:20:12.819 frankly, so counterintuitive. The weighted average 00:20:12.819 --> 00:20:18.890 DSCR for the entire pool was 1 .76x. 1 .76. That's 00:20:18.890 --> 00:20:21.269 great. I mean, that's way, way above the 1 .25 00:20:21.269 --> 00:20:22.730 safety zone we were just talking about. That 00:20:22.730 --> 00:20:24.789 sounds incredibly healthy. It is. It's a fantastic 00:20:24.789 --> 00:20:26.910 number on its own, but it gets even stranger. 00:20:27.190 --> 00:20:29.130 The original weighted average for the pool back 00:20:29.130 --> 00:20:31.430 in 2005 when those eight loans were presumably 00:20:31.430 --> 00:20:34.589 healthy was 1 .666. Wait, wait, let me get this 00:20:34.589 --> 00:20:37.299 straight. The pool. on average, got healthier. 00:20:37.420 --> 00:20:40.200 Yes. The weighted average DSCR actually improved 00:20:40.200 --> 00:20:43.799 from 1 .66 to 1 .76 over those few years. How 00:20:43.799 --> 00:20:46.299 is that even possible? You have 6 % of the pool 00:20:46.299 --> 00:20:49.119 collapsing, dropping 38 % in coverage, yet the 00:20:49.119 --> 00:20:50.859 overall average goes up. That doesn't make any 00:20:50.859 --> 00:20:53.740 sense. This is the danger of averages. It's a 00:20:53.740 --> 00:20:56.730 perfect illustration. While those eight specific 00:20:56.730 --> 00:20:59.750 loans were rotting from the inside out, the other 00:20:59.750 --> 00:21:03.589 127 loans were likely doing quite well. Maybe 00:21:03.589 --> 00:21:05.809 the owners of those properties were paying down 00:21:05.809 --> 00:21:08.250 their principal aggressively, which lowers their 00:21:08.250 --> 00:21:11.670 debt service. Maybe their rents went up. Since 00:21:11.670 --> 00:21:14.809 the calculation is weighted by loan size, the 00:21:14.809 --> 00:21:18.029 success of the healthy majority completely masked 00:21:18.029 --> 00:21:20.539 the catastrophic failure of the minority. That 00:21:20.539 --> 00:21:23.059 is such a crucial lesson. If you just looked 00:21:23.059 --> 00:21:25.859 at the headline number, portfolio DSCR improves 00:21:25.859 --> 00:21:28.480 to 1 .76, you'd think everything was perfect. 00:21:28.579 --> 00:21:30.859 You'd think, wow, what a solid investment. I 00:21:30.859 --> 00:21:32.579 should buy more. And you would be completely 00:21:32.579 --> 00:21:35.500 missing the rot in the foundation. You'd miss 00:21:35.500 --> 00:21:37.980 the fact that over $80 million worth of loans, 00:21:38.200 --> 00:21:40.859 eight loans at around $10 million each, were 00:21:40.859 --> 00:21:42.900 on the verge of default. It's like the Titanic. 00:21:43.630 --> 00:21:46.029 Imagine you calculate the average dryness of 00:21:46.029 --> 00:21:48.009 the passengers on the Titanic as it's sinking. 00:21:48.410 --> 00:21:50.190 Most of the people are still on the upper deck, 00:21:50.309 --> 00:21:52.009 sipping champagne, you know, waiting for the 00:21:52.009 --> 00:21:55.289 lifeboats. They are perfectly dry. A few hundred 00:21:55.289 --> 00:21:57.950 people in steerage are already underwater. But 00:21:57.950 --> 00:22:00.089 if you average it out across everyone, the report 00:22:00.089 --> 00:22:04.529 says status, mostly dry. That is a darker way 00:22:04.529 --> 00:22:06.910 to put it. But yes, it's a perfect analogy. The 00:22:06.910 --> 00:22:08.869 average depth of the water on the ship might 00:22:08.869 --> 00:22:11.569 be low. But for the people in the steerage, that 00:22:11.569 --> 00:22:14.269 average is meaningless. They're drowning. So 00:22:14.269 --> 00:22:16.569 for you listening, the takeaway here is don't 00:22:16.569 --> 00:22:18.549 just trust the top line number. You have to dig 00:22:18.549 --> 00:22:20.049 into the distribution. You have to look at the 00:22:20.049 --> 00:22:23.349 outliers. Absolutely. A high average DSCR doesn't 00:22:23.349 --> 00:22:25.589 guarantee safety if there is a concentrated pocket 00:22:25.589 --> 00:22:28.569 of extreme risk. And conversely, as we said, 00:22:28.670 --> 00:22:31.490 a DSCR below 1 .0 doesn't guarantee default. 00:22:31.990 --> 00:22:34.869 But it is a blinking red light that demands your 00:22:34.869 --> 00:22:37.150 immediate attention. You have to look at the 00:22:37.150 --> 00:22:39.650 loan level data. OK, speaking of looking closer, 00:22:39.789 --> 00:22:42.450 we need to move to the final section of our dive. 00:22:42.670 --> 00:22:44.569 And I'm going to warn you now, this is the advanced 00:22:44.569 --> 00:22:47.390 class. This is the double black diamond run of 00:22:47.390 --> 00:22:49.869 financial metrics for sure. We are going to talk 00:22:49.869 --> 00:22:52.890 about taxes and specifically a fundamental flaw 00:22:52.890 --> 00:22:57.349 in the standard DSCR calculation that, according 00:22:57.349 --> 00:23:00.230 to our sources, leads people to think they are 00:23:00.230 --> 00:23:03.670 safe when they are actually quietly going broke. 00:23:03.829 --> 00:23:06.670 The pre -tax provision method. It sounds incredibly 00:23:06.670 --> 00:23:09.519 intimidating. but the concept starts with a simple 00:23:09.519 --> 00:23:13.000 question how does the irs the tax authority treat 00:23:13.000 --> 00:23:15.880 your debt payments and the answer is inconsistently 00:23:15.880 --> 00:23:18.460 very inconsistently okay so let's start with 00:23:18.460 --> 00:23:21.400 the easy part we know that interest is tax deductible 00:23:21.400 --> 00:23:24.430 right if you run a business Interest is an expense. 00:23:24.650 --> 00:23:26.950 You subtract it from your income before you calculate 00:23:26.950 --> 00:23:29.930 your taxes. Right. So if you earn a dollar and 00:23:29.930 --> 00:23:32.109 you pay a dollar of interest, you have zero profit 00:23:32.109 --> 00:23:34.650 and you pay zero tax. You pay the interest with 00:23:34.650 --> 00:23:37.269 pre -tax dollars. Very efficient. But what about 00:23:37.269 --> 00:23:40.009 principal? Principal is not tax deductible. Repeat 00:23:40.009 --> 00:23:42.230 that for the people on the back. That seems really 00:23:42.230 --> 00:23:44.930 important. You cannot deduct principal repayment. 00:23:45.130 --> 00:23:48.069 You have to pay principal with after -tax dollars. 00:23:48.430 --> 00:23:50.170 Okay, I want to make sure I really, really get 00:23:50.170 --> 00:23:53.200 this. Let's say I have a lemonade stand. I borrowed 00:23:53.200 --> 00:23:56.160 money to build the stand. This year, I owe the 00:23:56.160 --> 00:24:00.759 bank $1 in principal. Okay. You owe $1. I sell 00:24:00.759 --> 00:24:03.819 enough lemonade to make exactly $1 of profit. 00:24:03.940 --> 00:24:06.480 I take that dollar, and I hand it to the banker 00:24:06.480 --> 00:24:09.319 to pay the principal. We're good, right? I'm 00:24:09.319 --> 00:24:13.670 all square. No. You... or in jail, or at least 00:24:13.670 --> 00:24:15.589 you're in very deep trouble with the IRS. Why? 00:24:15.829 --> 00:24:17.769 I made a dollar. I paid a dollar. I have nothing 00:24:17.769 --> 00:24:20.849 left. Because you made $1 of profit. The IRS 00:24:20.849 --> 00:24:23.849 wants its cut of that profit. Let's say the tax 00:24:23.849 --> 00:24:27.210 rate is 35%. The IRS wants 35 cents from you. 00:24:27.349 --> 00:24:29.549 But I gave the dollar to the banker. I don't 00:24:29.549 --> 00:24:31.869 have it anymore. The IRS does not care. They 00:24:31.869 --> 00:24:33.750 don't care what you did with the money. You earned 00:24:33.750 --> 00:24:36.369 the profit. You owe the tax. The fact that you 00:24:36.369 --> 00:24:39.650 used the cash to pay off a loan is your problem, 00:24:39.710 --> 00:24:42.099 not theirs. So in order to pay the banker that 00:24:42.099 --> 00:24:45.440 $1, I actually needed to earn more than a dollar. 00:24:45.599 --> 00:24:47.559 Exactly. You needed to earn enough to pay the 00:24:47.559 --> 00:24:49.759 taxman and still have a full dollar left over 00:24:49.759 --> 00:24:53.059 for the banker. This is the tax trap. Now, the 00:24:53.059 --> 00:24:55.859 standard DSCR formula, the simple NOI divided 00:24:55.859 --> 00:24:58.519 by debt, does it account for this? Generally, 00:24:58.539 --> 00:25:02.259 no. It treats all cash flow as equal. It assumes 00:25:02.259 --> 00:25:05.299 a dollar of cash is a dollar of cash. It forgets 00:25:05.299 --> 00:25:07.180 that some of those dollars have a tax toll on 00:25:07.180 --> 00:25:09.220 them before they can be spent on certain things. 00:25:09.660 --> 00:25:12.000 This leads to the distinction the sources make 00:25:12.000 --> 00:25:15.000 between EBITDA and EBITDA. These acronyms get 00:25:15.000 --> 00:25:18.579 thrown around a lot. Yes. EBITDA earnings before 00:25:18.579 --> 00:25:21.500 interest, taxes, depreciation, and amortization. 00:25:21.819 --> 00:25:24.900 It's a classic metric. The sources say EBITDA 00:25:24.900 --> 00:25:27.180 is great for measuring your ability to make interest 00:25:27.180 --> 00:25:29.779 -only payments. Because interest is pre -tax, 00:25:29.779 --> 00:25:32.059 so it matches up. Exactly. But if you have to 00:25:32.059 --> 00:25:34.420 pay principal, which is post -tax, you should 00:25:34.420 --> 00:25:36.660 be looking at EBITDA without the T for taxes. 00:25:37.240 --> 00:25:39.759 Or, more accurately, you need a method that actually 00:25:39.759 --> 00:25:42.160 accounts for the tax bite on the principal portion. 00:25:42.359 --> 00:25:44.900 Enter the pre -tax provision method. Right. This 00:25:44.900 --> 00:25:47.440 method tries to solve that exact problem by calculating 00:25:47.440 --> 00:25:50.059 exactly how much pre -tax cash you need to set 00:25:50.059 --> 00:25:52.720 aside or provide to meet all of your post -tax 00:25:52.720 --> 00:25:55.809 outlays. And post -tax outlays being things like 00:25:55.809 --> 00:25:59.069 principal payments, but also paying dividends 00:25:59.069 --> 00:26:02.049 to shareholders or any capital expenditures that 00:26:02.049 --> 00:26:04.589 you can't finance with new debt. Correct. Anything 00:26:04.589 --> 00:26:06.890 you have to pay with clean after -tax money. 00:26:07.089 --> 00:26:08.950 Okay. I want to walk through the logic of this 00:26:08.950 --> 00:26:11.730 calculation because it's really clever. It involves 00:26:11.730 --> 00:26:14.490 a comparison between your non -cash expenses 00:26:14.490 --> 00:26:17.670 and your post -tax outlays. It's a balancing 00:26:17.670 --> 00:26:20.309 act. On one side of the scale, you have your 00:26:20.309 --> 00:26:23.309 non -cash expenses, and the big one is depreciation. 00:26:23.410 --> 00:26:25.950 We talked about this earlier. Depreciation is 00:26:25.950 --> 00:26:28.309 a beautiful thing for cash flow because it shields 00:26:28.309 --> 00:26:30.390 your income from taxes. Right. You report a loss 00:26:30.390 --> 00:26:33.069 on paper, the depreciation, but you keep the 00:26:33.069 --> 00:26:35.390 cash. It's like a tax -free allowance from the 00:26:35.390 --> 00:26:37.390 government. So depreciation gives me a bucket 00:26:37.390 --> 00:26:42.160 of tax -free cash. Exactly. So scenario A. Let's 00:26:42.160 --> 00:26:44.240 say your depreciation for the year is greater 00:26:44.240 --> 00:26:46.519 than your principal payments. Okay, so my tax 00:26:46.519 --> 00:26:49.000 shield is bigger than the thing I need to shield? 00:26:49.200 --> 00:26:52.599 In this case, you are safe. You are in good shape. 00:26:53.119 --> 00:26:56.059 You can use that cash, which was shielded from 00:26:56.059 --> 00:26:58.839 taxes by the depreciation, to pay the principal. 00:26:59.319 --> 00:27:01.859 You don't take an extra tax hit. The provision 00:27:01.859 --> 00:27:04.279 is just the amount of the principal. One dollar 00:27:04.279 --> 00:27:07.019 debt needs one dollar of cash. Simple. Then there's 00:27:07.019 --> 00:27:09.819 scenario B, the ouch scenario, as the source 00:27:09.819 --> 00:27:12.019 calls it. This is where your principal payments 00:27:12.019 --> 00:27:14.740 are greater than your depreciation. You have 00:27:14.740 --> 00:27:17.240 exhausted your tax shield. You used up all your 00:27:17.240 --> 00:27:19.700 depreciation credits for the year, but you still 00:27:19.700 --> 00:27:22.440 owe more principal to the bank. So that extra 00:27:22.440 --> 00:27:24.420 amount of principal is exposed to taxes. It's 00:27:24.420 --> 00:27:28.119 unprotected. It is naked. To pay that extra unprotected 00:27:28.119 --> 00:27:30.599 principal, you must earn extra pre -tax income 00:27:30.599 --> 00:27:33.299 to cover the principal plus the taxes on that 00:27:33.299 --> 00:27:35.740 income. The sources give a really concrete example 00:27:35.740 --> 00:27:38.359 of this. Can we run the numbers? Let's do it. 00:27:38.460 --> 00:27:41.759 So imagine a company. They have post -tax outlays, 00:27:41.859 --> 00:27:44.319 let's just call it, principal for simplicity 00:27:44.319 --> 00:27:47.880 of $100 million. Okay, they owe the bank $100 00:27:47.880 --> 00:27:50.299 million in principal this year, a big bill. But 00:27:50.299 --> 00:27:52.740 their non -cash expenses, their depreciation 00:27:52.740 --> 00:27:55.500 is only $50 million. So they have a $50 million 00:27:55.500 --> 00:27:58.640 shield but a $100 million bill. There's a mismatch. 00:27:58.759 --> 00:28:01.019 Right. So the first $50 million of the debt is 00:28:01.019 --> 00:28:05.019 covered. It can be paid using that cash that 00:28:05.019 --> 00:28:07.299 was shielded by the depreciation. No tax problem 00:28:07.299 --> 00:28:09.460 there. But they still have another $50 million 00:28:09.460 --> 00:28:11.839 of principal left to pay. And no depreciation 00:28:11.839 --> 00:28:14.900 left to hide it from the IRS. Correct. So assuming 00:28:14.900 --> 00:28:17.299 a 35 % tax rate, they can't just go out and earn 00:28:17.299 --> 00:28:20.680 $50 million. If they earn $50 million, the IRS 00:28:20.680 --> 00:28:23.720 would take 35 % of that, which is $17 .5 million. 00:28:24.099 --> 00:28:26.660 That would leave them with only $32 .5 million. 00:28:27.299 --> 00:28:30.059 Not enough. Big shortfall. So they have to gross 00:28:30.059 --> 00:28:32.660 up that income. They have to aim higher. Yes. 00:28:32.700 --> 00:28:36.519 The formula is the shortfall divided by, in parentheses, 00:28:36.779 --> 00:28:40.339 1 minus the tax rate. So $50 million divided 00:28:40.339 --> 00:28:45.460 by 1 minus 0 .35. So $50 million divided by 0 00:28:45.460 --> 00:28:49.039 .65. Which comes out to... Roughly $77 million. 00:28:49.380 --> 00:28:52.380 Wow. So to pay that final $50 million of debt, 00:28:52.539 --> 00:28:55.259 they need to earn $77 million of pre -tax income. 00:28:55.519 --> 00:28:58.380 $27 million goes to the IRS. $50 million goes 00:28:58.380 --> 00:29:01.740 to the bank. That is huge. That is a $27 million 00:29:01.740 --> 00:29:05.799 hidden cost that the standard DSCR formula doesn't 00:29:05.799 --> 00:29:08.559 show you at all. Exactly. So let's add it all 00:29:08.559 --> 00:29:12.690 up. To pay the full $100 million debt, they need 00:29:12.690 --> 00:29:14.890 the original $50 million that was shielded plus 00:29:14.890 --> 00:29:17.130 the $77 million they had to earn to cover the 00:29:17.130 --> 00:29:21.930 taxable part. Total requirement, $127 million 00:29:21.930 --> 00:29:24.809 of pre -tax cash. So if you were just using the 00:29:24.809 --> 00:29:26.369 basic math, you'd look at the bill and think, 00:29:26.410 --> 00:29:29.069 I need $100 million. But in reality, because 00:29:29.069 --> 00:29:32.430 of the tax code, you need $127 million. And that 00:29:32.430 --> 00:29:36.190 gap, that $27 million gap. is where companies 00:29:36.190 --> 00:29:38.210 go bankrupt. They look at their standard DSCR, 00:29:38.390 --> 00:29:40.170 they think they have enough coverage, but the 00:29:40.170 --> 00:29:42.309 quarterly tax bill hits and suddenly the cash 00:29:42.309 --> 00:29:44.529 drawer is completely empty. They miscalculated 00:29:44.529 --> 00:29:46.910 reality. This is why the pre -tax provision method 00:29:46.910 --> 00:29:49.869 matters so much. It reviews the true actual cash 00:29:49.869 --> 00:29:52.650 cost of the debt. It answers the real question. 00:29:52.950 --> 00:29:55.150 How much do I really need to earn to keep the 00:29:55.150 --> 00:29:57.450 lights on and the bankers happy, considering 00:29:57.450 --> 00:30:00.680 Uncle Sam always eats first? It effectively de 00:30:00.680 --> 00:30:03.859 -risks the analysis. It's a much more conservative, 00:30:04.119 --> 00:30:06.599 much more realistic view of solvency. It is. 00:30:06.660 --> 00:30:09.140 And if you are out there analyzing a stock or 00:30:09.140 --> 00:30:11.119 looking at a company's books and you see they 00:30:11.119 --> 00:30:12.819 have massive principal repayments coming due 00:30:12.819 --> 00:30:15.579 and very little depreciation on their books, 00:30:15.759 --> 00:30:19.460 you need to be doing this math because the company 00:30:19.460 --> 00:30:21.920 might be a lot closer to the edge than it looks. 00:30:22.099 --> 00:30:25.380 Wow. OK, so we've gone from the basic pulse check 00:30:25.380 --> 00:30:28.180 all the way to advanced tax surgery. Let's zoom 00:30:28.180 --> 00:30:29.740 out and just summarize what we've learned today. 00:30:29.980 --> 00:30:32.359 Well, we started with the basic definition. GSCR 00:30:32.359 --> 00:30:34.900 is the sleep at night number. It's net operating 00:30:34.900 --> 00:30:37.400 income divided by total debt service. And we 00:30:37.400 --> 00:30:39.660 learned that the total debt part includes principal 00:30:39.660 --> 00:30:41.940 because cash is king. It's all about liquidity. 00:30:42.099 --> 00:30:45.000 And the income part excludes depreciation and 00:30:45.000 --> 00:30:46.920 interest because we want to see the raw engine 00:30:46.920 --> 00:30:49.559 power of the asset itself. Then we established 00:30:49.559 --> 00:30:53.400 the benchmarks. 1 .0 is bear survival. Anything 00:30:53.400 --> 00:30:57.359 less is a slow death by 1 ,000 cuts. 1 .25 is 00:30:57.359 --> 00:30:58.980 the general comfort zone for commercial real 00:30:58.980 --> 00:31:01.859 estate. But banks vary, and those loan covenants 00:31:01.859 --> 00:31:03.859 can trigger a default even if you're still making 00:31:03.859 --> 00:31:06.259 your payments. We looked at the S &P case study 00:31:06.259 --> 00:31:09.299 from 2008. The huge lesson there was, beware 00:31:09.299 --> 00:31:12.440 the average. A portfolio can look shiny and healthy 00:31:12.440 --> 00:31:16.440 on the surface 1 .76x coverage while having a 00:31:16.440 --> 00:31:19.660 cancerous tumor of bad loans, with a 38 % decline 00:31:19.660 --> 00:31:22.539 growing right inside it. And finally, we just 00:31:22.539 --> 00:31:25.180 tackled the pre -tax provision method. The critical 00:31:25.180 --> 00:31:27.240 realization that paying back principal is much 00:31:27.240 --> 00:31:28.819 harder than it looks because you have to pay 00:31:28.819 --> 00:31:31.519 taxes on that money first unless you have enough 00:31:31.519 --> 00:31:33.700 depreciation to shield it. So what does this 00:31:33.700 --> 00:31:35.539 all mean for you listening? Why should you care 00:31:35.539 --> 00:31:38.440 about this dry, academic -sounding ratio? I think 00:31:38.440 --> 00:31:40.839 it comes down to reality testing. Whether you 00:31:40.839 --> 00:31:43.359 are buying a rental property, analyzing a stock 00:31:43.359 --> 00:31:45.400 for your portfolio, or running a small business, 00:31:45.640 --> 00:31:49.160 this ratio strips away all the noise. Accounting 00:31:49.160 --> 00:31:51.619 can be creative. Net income can be manipulated 00:31:51.619 --> 00:31:55.660 with all sorts of tricks. But DSCR, it's raw 00:31:55.660 --> 00:31:58.480 cash reality. Can you pay the bills or not? It's 00:31:58.480 --> 00:32:01.119 the truth serum of finance. It really is. It 00:32:01.119 --> 00:32:02.900 doesn't lie. Before we go, I have a thought I 00:32:02.900 --> 00:32:04.839 want to throw at you. It stems from that S &P 00:32:04.839 --> 00:32:07.279 surprise. Let's hear it. We saw how a portfolio 00:32:07.279 --> 00:32:09.880 could improve its average health while specific 00:32:09.880 --> 00:32:13.259 parts of it were rotting. That 6 % of loans that 00:32:13.259 --> 00:32:17.460 were just collapsing. It makes me wonder. When 00:32:17.460 --> 00:32:20.279 we look at the wider economy, are we making the 00:32:20.279 --> 00:32:23.319 same mistake? We hear headlines all the time. 00:32:23.319 --> 00:32:26.380 Average GDP is up or average unemployment is 00:32:26.380 --> 00:32:29.180 down. But does that high level comforting average 00:32:29.180 --> 00:32:32.980 high deep structural rot in specific sectors 00:32:32.980 --> 00:32:35.339 or demographics? Are we looking at the shiny 00:32:35.339 --> 00:32:37.579 average and missing the cracks in the foundation, 00:32:37.640 --> 00:32:40.220 just like the investors in that 2008 mortgage 00:32:40.220 --> 00:32:43.660 pool? That is a profound question. We often optimize 00:32:43.660 --> 00:32:45.940 society for the average and completely ignore 00:32:45.940 --> 00:32:48.900 the distribution. In that S &P pool, ignoring 00:32:48.900 --> 00:32:51.299 the tail risk of those eight bad loans led to 00:32:51.299 --> 00:32:54.240 a sudden downgrade. In the wider economy, ignoring 00:32:54.240 --> 00:32:56.299 the pockets of distress because the average looks 00:32:56.299 --> 00:32:58.579 fine usually leads to social and economic shocks 00:32:58.579 --> 00:33:01.180 that nobody in charge seems to see coming. Something 00:33:01.180 --> 00:33:03.079 to mull over the next time you see a headline 00:33:03.079 --> 00:33:05.579 about record highs. Indeed. Always check the 00:33:05.579 --> 00:33:07.680 denominator and the outliers. Words to live by. 00:33:07.819 --> 00:33:09.500 Thanks for listening to this deep dive. We'll 00:33:09.500 --> 00:33:10.119 catch you in the next one.