A bank would prefer to know exactly how much money is available to pay interests, not just an approximation. Let's point out that after NOI there are still CapEx, Taxes, Admin Fees to pay. So why focusing on NOI instead of UFCF?
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The primary "below the line" (below NOI anyway) items you typically see are capex, tenant improvements, and leasing commissions. These can indeed be significant expenses. Lenders have a few ways of addressing this.
If the property is "unstabilized" (meaning there is significant work and/or vacancy to address and considerable cost in doing so) the lender will often structure a holdback or reserve. In other words, the lender will target a certain level of proceeds it is ultimately okay advancing to borrower, and will reduce that amount by whatever stabilization costs are budgeted. The lender will then advance cash from the reserve when there is proof those capital expenses have been paid, or once the property has achieved targeted operating performance. That way NOI more or less represents the cash flow that will be available from the property to cover debt service.
Alternatively, for a stabilized property, a lender might add a "capital reserve" line item in the formula used to calculate the debt service coverage ratio. So NOI as an owner thinks about it may not be the same (and is generally higher) than the NOI amount that the lender uses in its covenant test. When negotiating loan docs, it's important to pay careful attention to how these calculations work.
There are many other approaches (cash flow sweeps, springing letters of credit or springing recourse, etc), but in general NOI is used to approximate the long-run ability of the property to generate cash available for debt service, and one-time lumpy capital items are addressed separately.
Good stuff. I will add that lenders may even require many separate reserve accounts simply based on asset profile. Office space that is characterized by a few, large tenants with significant role during the term may require multiple tenant specific TI reserves.
Agreed. Lenders will also distinguish between NOI DSCR and other expenses.
True, but realistically in this lending environment, lenders are being pretty aggressive with lending terms. Our delinquent rate is something like 0.2%, so we're obviously pretty conservative, and we are not requiring those reserves since competition for these top borrowers is intense.
All of those things you listed are considered when making a mortgage. DSCR is just one metric and obviously not used alone. RE taxes, replacement reserve (ongoing cap ex) and management fees ("admin expense") are all included in underwritten NOI anyways. If there are big cap ex projects on the horizon the PCA will note them and the lender may require a reserve from loan proceeds be set aside for it.
Also, outside of the RE context many of those below the line items are somewhat discretionary. Yes I understand taxes is a big one that isn't really and there are certainly others but for ease of use and comparability the NOI is used. In the instance of say something like capex, a company is not likely going to default in order to build sink some money into a capital project.
taxes after NOI? not in my experience
I don't believe the OP was referring to RE taxes, I think he means income taxes, which are certainly irrelevant. Also, when you say "admin fees" are you referring to something along the lines of an Asset Management fee or management fees? In the case of a below the line asset management fee, this would be taken into account by the lender, but not necessarily used in DSCR calculation.
We definitely add in leasing commissions, tenant improvement reserves and replacement reserves to the above the line calculation when determining DSCR in underwriting; however, for DSCR covenants we use actual cash flow and debt service.
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