Debt Service Coverage Ratio (DSCR) loans are a specialized product and servicing them necessitates a meticulous and specialized approach. Investors seeking to realize maximum profits from DSCR portfolios will find it's crucial to have a proficient mortgage servicing partner. A mortgage servicer with limited knowledge or specialization in DSCR loans can cause a multitude of problems.
To better understand this issue, let’s review the potential risks and challenges associated with inexperienced DSCR servicers and explore strategic approaches investors can adopt to assess servicers.
Risk: Covenant Violations
A servicer that neglects to confirm covenant compliance is like a tenant who ignores the fire alarm in a building you own. It exposes you to unexpected risks and potential financial losses that could have been prevented had they just heeded the warning.
DSCR loans entail a comprehensive list of covenants that need to be consistently tracked and passed through to the investor. A servicer lacking specialization may miss vital covenant-related details, creating information gaps. Missing these early warnings will hinder strategic decision-making for investors.
A proficient servicer diligently confirms all financial, operational, reporting, and additional financing covenants appearing in the DSCR loan and guaranty agreements.
Strategic solution: Ask to see your servicer’s process, schedule, and reports that track covenant compliance. Manual reports are a red flag.
Risk: Inadequate P&L Review
For optimal risk management, it's imperative to have meticulous quarterly and annual P&L reviews. An inexperienced servicer may overlook discrepancies and red flags, potentially leading to financial anomalies that jeopardize your investment.
Strategic solution: Ask for the resumes of the servicer’s employees who perform P&L reviews and require notice/updates about staffing changes.
Risk: Using Single-family Technology to Service Commercial Loans
Using a single-family servicing system for commercial loans is like cooking a gourmet meal for 100 over a campfire. You can do it, but it’s faster, easier, and more efficient to do your cooking in a commercial kitchen and the product produced is going to be a lot better.
Take, for example, the tracking of covenant violations and P&Ls. A commercial system will capture covenants and schedule reviews. When problems arise, the system will launch a workflow to notify the borrower and investor of violations, track remediation, and in a worst-case scenario, declare the borrower in default.
None of those are actions familiar to traditional single-family servicing professionals, nor are they typically managed by single-family servicing systems. DSCR loans may be secured by single-family residences, but they’re taken out by commercial borrowers not residential borrowers.
Strategic Solution: Choose a servicer with a proper commercial loan servicing platform that provides robust asset management and reporting to investors.
Risk: Equity Skimming and Shifting Cash Flows
As economic conditions fluctuate, an unspecialized servicer might miss instances of equity skimming or the redirection of cash flows to cover other debts. Without proper scrutiny and questioning, investors might be left in the dark about the real financial health of their borrowers and property operations, potentially leading to significant losses.
Servicers need to be well versed in interpreting financial statements and property operating statements to eliminate the risk of skimming.
Strategic solution: Make sure your servicer is requesting the rent rolls to understand the monthly cash flow for each loan.
Risk: Failure to Escrow or Timely Remit Insurance and Tax Payments
A servicer that fails to accurately calculate escrow projections may end up short of funds to pay insurance or property taxes. We’ve seen prior servicers instruct DSCR borrowers to pay a portion of insurance and tax bills, leaving the investor to cover the remainder. In these scenarios, confirming the payments becomes a daunting task, leading to possible fiscal discrepancies.
Since DSCR loans often lack the consistent origination workflows long used for agency single-family loans, taxes and insurance payments that should be received at closing sometimes aren’t collected. Those errors should always be remedied in a way that avoids early payment default.
Strategic solution: Make sure your servicer is tracking delinquent taxes and insurance. This can often be difficult when there are multiple rental properties and leveraging an outside tracking service may be necessary.
Risk: Failure to Timely Report Bankruptcy Declarations
Commercial side bankruptcy declarations can be catastrophic. An uninformed or inexperienced servicer may delay relaying this critical information to the investor. Not being first in line to know about financial problems can severely affect repayment and the ability to foreclose to satisfy the lien.
Strategic solution: Discuss the frequency of and method by which your servicer tracks and reports bankruptcy filings.
Navigating the DSCR mortgage terrain demands a skilled servicer. The pitfalls of inexperienced servicing, from overlooking covenant violations to missing bankruptcy declarations, can be costly. Given these risks, savvy investors seek out servicers with commercial expertise. In the end, the right servicer can mean the difference between smooth sailing and turbulent waters. Choose with care.