Negative DSCR in first year's cash flow
I am working on a case study for an office acquisition. In the first year of cash flows, the NOI is negative and not high enough to cover the debt repayments (principal + interest).

How do I understand this intuitively? What does it mean in a practical sense... that the fund will not receive the loan?

In a waterfall (REPE) model, I assume that an equity cure would be the method to inject equity to cover the debt.

Thanks!
[{"id": "dv4esgd", "text": "You can capitalize the interest shortfall into the loan and have it come out of loan proceeds. This happens all the time when people are doing value add improvements and need the property vacant to renovate. To simplify, purchase price is 10M, interest shortfall is 500K in first year. Instead of getting a $6M loan you get a $6.5Mish loan. This is called an interest reserve.", "replies": [{"id": "dv69vbh", "text": "And that extra 500k is used to make the first few months loan payment?", "replies": [{"id": "dv6ef47", "text": "Yep", "replies": [], "depth": 3}], "depth": 2}, {"id": "dv7on6o", "text": "But what if the NOI doesn\u2019t cover the principal repayments as well? \nSo the DSCR is totally negative. My assessors will probably think I\u2019m a total idiot for leaving it negative...\n", "replies": [{"id": "dv9238j", "text": "Generally when a loan has a low DSCR but there are reserves or fundings built in to the deal &amp; debt funds just mark it as a 1 since they have the money in escrow or have control of the funds the make sure the debt service gets paid. In reality you're just putting out dollars to pay yourself to carry the property until it either starts generating NOI or the property is sold and the loan paid off", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "dv4f1un", "text": "As the first poster stated if this is a construction loan or acquisition that has value add components, it\u2019s typically to have \u201ccapitalized interest\u201d in the budget of the borrower as they know they will not have tenants in place for some period of time. As it stabilizes, the property should cover the DS if you have a competent borrower/developer. \n\nIf it\u2019s a stabilized property, then you\u2019re either not underwriting it correctly or you are and they definitely wouldn\u2019t get a loan. Banks aren\u2019t going to lend on something that is negative cash flow or even close to it ", "replies": [], "depth": 1}, {"id": "dv4h6i3", "text": "There are many ways that lenders will treat this. This might be more than what you're asking for, but it could help. First, you gotta recognize that you have two things going on here:\n\n1. Operating Shortfall: occurs when there is negative NOI. Simple right? In an unlevered deal, this means you would need to infuse equity to pay for the expenses. In a levered deal, the bank would make sure you've identified that as a cost when sizing the loan. Well talk about how they consider it below.\n\n2. Interest Shortfall: occurs when your NOI (BEFORE capital expenses--this is because the lender would have priority in claiming the positive NOI before you could use it to fund CapEx) doesn't fully cover your interest expense. You could have positive NOI and still have an interest shortfall (e.g., NOI of $10 and interest expense of $15 equates to a $5 dollar shortfall). Now, there are many many ways that lenders will draft terms to work around cash-strapped deals. To keep it simple, I'm only going to talk about 4 methods of dealing with shortfalls. However, know that banks will do many creative things like sweep all your positive cash flow or change their interest structure to PIK.\n\n4 Easy-to-Understand Methods that Lenders Use to Deal with Interest Shortfalls (assuming Equity-First Financing):\n\n1. They can require the owner to size the expected shortfall (NOI and interest) and fully fund it into a reserve account with equity at loan close. As the interest shortfall occurs, your equity is pulled out of the reserve account to pay for it.\n\n2. The lender sizes the shortfall into the loan and as shortfalls occur the lender pays for it with loan proceeds (out of one pocket and into the other). As a side note, this is the most common debt terms we've seen in our shop for the past 12 months.\n\n3. The bank can also size the shortfall, set it aside in a 'reserve account', mark it as drawn immediately at close, and make you pay interest on the reserve throughout the life of the loan. This is obviously circular (woot woot excel) and pretty onerous as well.\n\n4. The lender makes you pay the shortfall with equity as it occurs. This is less common, because it lowers your LTC because you've typically already reached the equity contribution mark.\n\nHope that helps you wrap your head around it a little more.\n", "replies": [{"id": "dv7oveb", "text": "Is point two referring to payment-in-kind loans? Where the debt service is covered by providing more debt as it is needed?", "replies": [{"id": "dv8td7a", "text": "Mechanically, yes, you can think of it as the same. \n\nHowever, just be aware that I haven't heard the term PIK used in this context (not that is incorrect). ", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}, {"id": "dv8pu0r", "text": "If it\u2019s a bridge loan it\u2019s typically an interest only loan. There is no payment of principal.", "replies": [], "depth": 1}, {"id": "dvd1re0", "text": "How on earth can you have NEGATIVE NOI?", "replies": [{"id": "dvdo2wr", "text": "If you have no tenants and your have to cover operating expenses", "replies": [{"id": "dve23p4", "text": "NOI starts with PGI.  Show me how you calculate a negative NOI.", "replies": [], "depth": 3}], "depth": 2}], "depth": 1}]