Debt Service Coverage Ratio, or DSCR, is one of the most important ratios when it comes to real estate financial modeling.
When we talk about debt service, what we are really talking about is loan payments. The debt service coverage ratio can easily be understood as Net Operating Income (NOI) divided by Annual Debt Service on the loan. This ratio becomes vital when underwriting commercial real estate loans. It is often used when a lender is determining the maximum loan principal they’re willing to lend on a certain income-producing property, or to measure the financial health of an existing property.
Below we explain the details of what debt service coverage ratio is, why you’ll want to start using it, and exactly how it works. With some practice and patience, using DSCR in your commercial real estate financial models can lead to smarter investing and a healthier financial future.
DSCR is what lenders use to determine the maximum loan amount for a given level of income. Lenders require a minimum level of income to provide a cushion in terms of ability to make mortgage payments, in the event that the property does not provide as much income as expected. DSCR can be calculated by dividing a property’s Net Operating Income by its Annual Debt Service, as per the below.
Debt Service Coverage Ratio = Net Operating Income / Annual Debt Service
DSCR is generally represented in the form of a number rounded to the hundredths decimal point. For example, you could have a DSCR of 1.35 or 0.75.
Lenders are looking for a DSCR on your property that is going to tell them that the net operating income of your property is enough to service the new mortgage payments. Most lenders will want at least a 25% cushion on the average deal. This 25% cushion translates to a 1.25 debt service coverage ratio coverage.
If your property’s NOI is more variable than most, it’s likely that your lender is going to require a larger cushion or a higher DSCR. For example, higher ratios are generally required for hotels (due to unstable income) and lower ratios are required for properties with long term leases signed.
In general, a DSCR higher than 1.00 means that there is sufficient cash flow to cover the loan. On the other hand, a debt service coverage ratio lower than 1.00 means that there is not enough cash flow to cover the loan obligation. Properties with DSCRs below 1.00 are generally considered high risk by lenders and are often in significant distress.
Below is a list of typical minimum debt service coverage ratios lenders like to see for different asset classes, keeping in mind that there are large variances individual to each deal:
The best way to get a grasp on debt service coverage ratio is to see it in action.
Below are the steps for how to use debt service coverage ratio in your commercial real estate financial model, in order to estimate the largest loan that the property qualifies for.
In summary, lenders utilize debt service coverage ratio to calculate the maximum loan value that they’d be willing to provide on your property. Lenders will continually monitor the property’s DSCR, in order to predict which loans may be at risk of default. Commercial real estate professionals would do well by calculating their DSCR before approaching lenders as well as on an ongoing basis, to monitor the financial health of their investment.