Debt Service Coverage Ratio Definition
The DSCR or debt-service coverage ratio is a way to compare operating income to debt service. In commercial real estate, this means looking at the subject’s property’s net operating income to the mortgage debt service. Both NOI and mortgage debt service is calculated on an annual basis.
Further explained, the reason that calculating the debt service coverage ratio is critical is that it helps you understand if there will be enough cash flow to account for and take on new mortgage debt.
DSCR Ratio Formula
Essentially, the equation comes out to be the net operating income divided by the total debt service.
DSCR Formula= NOI/Debt Service.
For example, if a property has a net operating income of $60,000 and a debt service of $50,000, the debt service coverage ratio would be 1.2.
If a DSCR comes out to be more than 1.0, this shows that there is, in fact, enough cash flow to account for debt service. If a DSCR is below 1.0, this means that there is not sufficient cash flow to cover debt service. It should be noted that even though a DSCR is 1.0, there may still be some more that is necessary and required.
Lenders typically require that a debt service coverage ratio ends up being more than 1.0. This provides a security blanket in the event that something winds up going south with a deal. The goal is to have enough of a gap to allow for some “Net Operating Income” (NOI) decline without compromising debt service obligations.
There really is not a minimum or ideal debt service coverage ratio. It actually can vary by the type of property, the bank, or the type of loan the buyer is attempting to secure. It can be stated that the basic DSCR requirements are usually between 1.2x and 1.4x. Typically, properties that are very stable and secure happen to weigh in at the lower end, closer to 1.2x. When a property is a risk or the buyer has much shorter-term leases and does not have the best credit scores, they weigh in on the higher end of this DSCR requirement scale range.
This range implies that an asset is able to produce an extra 20% of add-on income after all debt payments have been made.
NOI and DSCR
When there are large adjustments made by the lender to the Net Operating Income(NOI), this impacts the DSCR and must be accounted for. One thing that can happen is that the lender may want to add in some reserves for replacement in the NOI calculation and may want to include a provision for a management fee. This is important to note because the lender’s primary concern is whether or not the person attempting to acquire the loan has enough flow of funds to cover the debt service. In this case, banks and lenders will put into place some adjustments to the NOI in the form of deductions.
Lenders will deduct savings in the form of reserves. Reserves are the savings an individual has put into place to cover future anticipated capital expenditures. These capital expenditures may be extensive renovations, repairs, or replacements that are deemed to be necessary in order to properly take care of and maintain the property over many many years and will eventually have an impact on the borrower’s ability to service debt. If a foreclosure takes place, a professional management team will be paid from the project’s Net Operating Income to operate the property further. Even though an owner-managed property may lead to the owner saving a few bucks along the way, the lender or bank typically will not write in these savings into the DSCR calculation.
Other pieces of the equation of which a lender sometimes takes out of the NOI calculation are occasional tenant improvement and leasing commissions. These commissions are put into place in order to bring in tenants and fill up any vacancies.
Taking all of the property’s necessary expenses into account is absolutely paramount to accurately calculate the DSCR and proceed to underwrite a mortgage loan.
Calculating the DSCR for a Business
The DSCR comes into play when an advisor proceeds to examine and analyze a business’ financial statements, securing a business loan, when looking into tenant financials, or when setting out to find financing for an owner-occupied commercial real estate.
When it comes to a business and DSCR, the equation is the same. You will still take the cash flow and divide it by the debt service. The general concept of taking cash flow and dividing by debt service is the same. When it comes to calculating this for a business, you will not even look at the NOI. Instead, another measure of cash flow will be necessary to show that the business is able to pay debt obligations.
Because of this, Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) will be used. Sometimes, a particular type of EBITDA is used in substitution. These adjustments include can involve giving back a capital expenditure amount that is deemed essential to be able to replace fixed assets and adding in working capital changes. By adding in working capital changes, this will allow for coverage for investments in receivables and inventory.
The Global DSCR
Figuring out the debt service coverage ratio by using the standard formula will not always allow for enough transparency. It is crucial to have all of the information on both the business and the owner to know the details on the cash flow and also the debt service coverage ratio.
The DSCR is very important to know and comprehend for those who are underwriting commercial real estate and business loans. Suppose you are looking into tenant financials or trying to find and secure financing for owner-occupied commercial real estate. By understanding what the debt service coverage ratio is and how to calculate it, you are on your way to better determining the underwriting process. It is clear that the DSCR is comprised of a short and a simple calculation; its components prove to be complicated and often confusing.