Interest cover worked on one property loan, at the actual rate and at the stressed rate a lender sizes on, with the headroom it leaves and the loan it supports.
The interest cover ratio (ICR) is net operating income divided by annual interest, and the minimum a lender sets matters less than the rate it is tested at: often a stressed rate rather than the rate actually paid. On an illustrative 32,000,000 property with 2,000,000 of NOI, a 60 per cent loan at 5.00 per cent covers 2.08x. Tested at a 7.00 per cent stressed rate against a 1.75x minimum, the same property supports only 16,326,531, a 51.0 per cent loan-to-value instead of 60.
Worked in full in Real Estate Finance by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Interest cover is the usual coverage test in UK and European property loans, which are often interest-only or lightly amortising; US lenders more often quote DSCR, which adds principal. The ratio is simple. What makes it bind is the rate it is computed at, and that is where loan offers differ.
| Input | Value |
|---|---|
| Market value | 32,000,000 |
| Net operating income (a 6.25% yield) | 2,000,000 |
| Maximum loan-to-value | 60% |
| All-in interest rate, hedged | 5.00% |
| Stressed rate the lender tests at | 7.00% |
| Minimum ICR (illustrative) | 1.75x |
Loan = 32,000,000 × 60% = 19,200,000
Interest = 19,200,000 × 5.00% = 960,000
ICR = NOI ÷ interest = 2,000,000 ÷ 960,000 = 2.08x
In Excel: =NOI/(Loan*Rate)
Against a 1.75x minimum that leaves headroom of 1 − 1.75 ÷ 2.08 = 16.0 per cent: NOI can fall to 1,680,000 before the test fails. On this basis the loan-to-value test is the one that binds, since 1.75x on the actual rate would support 22,857,143, 71.4 per cent of value.
Stressed interest = 19,200,000 × 7.00% = 1,344,000; stressed ICR = 2,000,000 ÷ 1,344,000 = 1.49x
Maximum interest = NOI ÷ minimum ICR = 2,000,000 ÷ 1.75 = 1,142,857
Maximum loan = maximum interest ÷ stressed rate = 1,142,857 ÷ 7.00% = 16,326,531
In Excel: =MIN(Value*Max_LTV, NOI/Min_ICR/Stress_Rate)
The 60 per cent loan fails the stressed test at 1.49x, so the ICR now binds: the borrower gets 2,873,469 less, 15.0 per cent of the loan it expected. The consolation is real but often missed. On the smaller loan the interest actually paid is 816,327, so the actual ICR is 2.45x and NOI can fall 28.6 per cent before a 1.75x covenant is breached.
| Rate | Interest on 19,200,000 | ICR | Max loan at 1.75x | Binding loan | LTV |
|---|---|---|---|---|---|
| 4.00% | 768,000 | 2.60x | 28,571,429 | 19,200,000 | 60.0% |
| 5.00% | 960,000 | 2.08x | 22,857,143 | 19,200,000 | 60.0% |
| 6.00% | 1,152,000 | 1.74x | 19,047,619 | 19,047,619 | 59.5% |
| 7.00% | 1,344,000 | 1.49x | 16,326,531 | 16,326,531 | 51.0% |
| 8.00% | 1,536,000 | 1.30x | 14,285,714 | 14,285,714 | 44.6% |
The switch point is 5.95 per cent: above it, interest cover rather than loan-to-value sets the loan. On a 6.25 per cent yielding property that is a narrow margin, only 95 basis points above today's rate. Below it, cheaper debt does not raise the loan at all, because the LTV cap is reached first.
| Minimum ICR | Maximum loan | LTV |
|---|---|---|
| 1.50x | 19,047,619 | 59.5% |
| 1.75x | 16,326,531 | 51.0% |
| 2.00x | 14,285,714 | 44.6% |
| 2.25x | 12,698,413 | 39.7% |
Read the term sheet for three words: the rate (actual, hedged, or a stressed or "notional" rate), the income (historic twelve months or projected), and the period (one quarter annualised, or twelve months). A 1.75x covenant on projected income at the hedged rate and a 1.75x test on historic income at a stressed rate are different loans.
ICR ignores principal. With 25-year amortisation at 5.00 per cent, the 19,200,000 loan carries debt service of 1,362,287 a year, of which 402,287 is principal in year one, and the DSCR is 1.47x where the ICR is 2.08x. Neither is wrong; they answer different questions. ICR asks whether the income pays the cost of the money, DSCR whether it also repays it. The usual DSCR thresholds are discussed in what is a good DSCR for a commercial real estate loan.
The common mistake is to size the loan on the actual rate and assume the covenant will look after itself. A floating-rate borrower who takes the full 60 per cent at 2.08x has 16.0 per cent of NOI headroom today and none once rates rise 95 basis points, unless the hedge covers the term. Size on the stressed rate, or hedge the whole loan for the whole term, and quote the headroom on the rate the lender will actually test.
ICR is NOI over interest; the threshold matters less than the rate it is applied to. Here a 1.75x test cuts a 60 per cent loan to 51.0 per cent the moment it is run at 7.00 rather than 5.00 per cent. The sizing sheet that ranks interest cover against loan-to-value and debt yield is in the free workbook for this case, and the three tests can be run on your own figures in the loan sizing template.
ICR divides NOI by interest only; DSCR divides it by interest plus scheduled principal. On a 19,200,000 loan at 5.00 per cent, interest is 960,000 and ICR 2.08x, while 25-year amortisation adds 402,287 of principal in year one, so debt service is 1,362,287 and DSCR 1.47x on the same income.
One minus the covenant over the actual ratio. At 2.08x against a 1.75x covenant, NOI can fall 16.0 per cent, from 2,000,000 to 1,680,000. On the smaller loan sized at the stressed rate, the actual ICR is 2.45x and the headroom 28.6 per cent.
Because a floating loan's interest can rise during the term while the income does not. At 6.00 per cent the illustrative 60 per cent loan already falls to 1.74x; the rate that breaches 1.75x is 5.95 per cent, only 95 basis points above today's. Sizing at 7.00 per cent builds that cushion in on day one.
This article is one calculation from Real Estate Finance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 1340 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.