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DSCR: Debt Service Coverage Ratio
Debt service coverage ratio or DSCR, is a comparison between net operating income and debt service on an annual basis and is generally one of the most important considerations when a commercial mortgage broker, lender or bank is underwriting a loan.
- What is DSCR: Debt Service Coverage Ratio?
- DSCR Calculator
- Debt Service Coverage Ratio Formula and Example
- What are the DSCR Requirements for a Commercial Mortgage?
- DSCR vs. LTV for Commercial Loans
- How Commercial Lenders Calculate Net Operating Income (NOI) for DSCR
- DSCR vs. Debt Yield as a Measure of Loan Risk
- DSCR vs. Debt Yield Example
- Related Questions
- Get Financing
What is DSCR: Debt Service Coverage Ratio?
Debt service coverage ratio, or DSCR, compares a property’s annual net operating income (NOI) to its annual debt payments. By looking at a property's DSCR, a lender can determine whether a project is taking in enough operating income to cover its debts. DSCR is one of the most important considerations when a commercial mortgage broker, lender, or bank underwrites a loan.
DSCR Calculator
Debt Service Coverage Ratio Formula and Example
DSCR can easily be calculated by using the formula below:
For instance, a commercial property with a net operating income of $1,000,000 and a debt service of $900,000 would have a DSCR of $1,000,000 ÷ $900,000, or 1.11 (the income is 1.11x the annual debt service).
A debt service coverage ratio of 1 means a property is generating enough income to make its loan payments, while DSCR of less than 1 means it is not. Therefore, commercial lenders always want a project to have a DSCR higher than 1 to reduce the likelihood of a default or foreclosure. It’s important to realize that DSCR may change with manipulation of the loan terms, such as amortization, in order to increase or reduce annual debt service.
What are the DSCR Requirements for a Commercial Mortgage?
The general starting point for commercial mortgages is a 1.25x DSCR. However, this number fluctuates depending on who the lender is, the property type, the submarket, amortization, and other factors. The "x," which is sometimes included in DSCR, means that the project's NOI covers the project's debts 1.2 times. To calculate the net operating income, lenders subtract gross income from anticipated operating expenses. To calculate the debt service, lenders simply add up the annual principal and interest payments.
Typically, DSCR requirements are higher on riskier property types, such as hotels, since their income varies based on competition, seasonal factors, and other economic trends. Many lenders prefer hotels to have a DSCR of 1.40x before approving a loan. In comparison, DSCR requirements are often relaxed for properties in which national tenants have signed a long-term, triple net lease. These leases are called credit tenant leases (CTLs), and may allow a borrower to get approved with a DSCR as low as 1.05x. In addition, certain types of multifamily financing, such as HUD multifamily loans and some types of Freddie Mac® and Fannie Mae® multifamily loans, may also allow DSCRs as low as 1.05x for properties with an affordability component.
In general, average property type DSCR requirements include:
1.40x for self-storage
1.25x for industrial
1.25x for multifamily
1.25x for offices
1.50x for assisted living
Market expenses
Potential vacancy
Any off-site management expenses (even if the borrower's property is owner-managed, and does not have any)
Tenant improvement and leasing commissions (TI/LC) (for office and retail transactions)
What is an optimal debt service coverage ratio?
- Properties with a DCR of 1 or higher are considered to be profitable, whereas those with DCRs lower than 1 are considered to not be profitable. Lenders require 1.2 as a minimum DCR.
What is the definition of Debt Service Coverage Ratio (DSCR)?
Debt Service Coverage Ratio (DSCR) is a measurement of an entity’s cash flow vs. its debt obligations. In multifamily and commercial real estate, that entity is typically an income-producing property, while in corporate finance, the entity is usually a business or corporation. If an entity has a DSCR less than 1, its income is less than its monthly debt obligations. In contrast, if an entity has a DSCR of 1, then its income is equal to its monthly debt obligations, while if it has a DSCR of more than 1, its income is greater than its monthly debts.
DSCR (Debt-Service Coverage Ratio) is defined as the cash flow necessary to pay debts - interest, principal, lease payments, etc. It is used by lenders to determine loans on income properties. DSCR requirements are different for different types of HUD multifamily loans, however, HUD 223(a)(7) loans are subject to a maximum DSCR of 1.11x (for-profit entities) or 1.05x (nonprofit entities).
How is Debt Service Coverage Ratio (DSCR) calculated?
Debt Service Coverage Ratio (DSCR) is calculated by dividing the net operating income (NOI) of a property by the total debt service (TDS) of the property. The formula is:
DSCR = NOI / TDS
NOI is the total income of a property minus its operating expenses. TDS is the total amount of debt payments due each month, including principal, interest, taxes, and insurance.
For more information, please visit https://multifamily.loans/dscr-calculator/.
What is a good Debt Service Coverage Ratio (DSCR) for commercial real estate financing?
In most commercial real estate financing cases, lenders prefer properties with DSCRs of 1.25x or more, but a lender’s DSCR requirements depend on a combination of the borrower’s financial strength, the type of property, and other factors. For example, while lenders may require a minimum DSCR of 1.25x for multifamily properties, property types normally deemed riskier than multifamily properties — such as hotels or retail assets — could see that requirement expand as high as 1.40x or 1.50x. Source
When a lender is evaluating a borrower for a multifamily or commercial real estate loan, DSCR is one of the most important factors that they will take into account. This is because it’s one of the best predictors of whether a borrower will be able to pay back a loan on time. In most cases, lenders prefer properties with DSCRs of 1.20x or more, though the required DSCR will typically depend on the financial strength of the borrower, the type of property in question, and other factors. For instance, while multifamily apartment properties may need a minimum DSCR of 1.20x to qualify for funding, riskier property types, such as hotels or self-storage facilities, may need a DSCR of 1.40x- 1.50x in order to qualify. Source
What are the benefits of having a high Debt Service Coverage Ratio (DSCR)?
Having a high Debt Service Coverage Ratio (DSCR) is beneficial for borrowers because it indicates that they have sufficient income to cover their debt obligations. A DSCR of 1.25 or higher is often considered “strong” by lenders, and it can help borrowers qualify for more favorable loan terms. A high DSCR also indicates that the borrower is less likely to default on their loan, as they have sufficient income to cover their debt obligations. Additionally, a high DSCR can help borrowers secure lower interest rates and longer loan terms.
Sources:
What are the risks of having a low Debt Service Coverage Ratio (DSCR)?
Having a low Debt Service Coverage Ratio (DSCR) can be a sign of financial hardship and can be a red flag to lenders. A DSCR of less than 1.00 reflects a negative cash flow, which, to lenders means that the borrower will be unable to cover the costs of their debt obligations without needing to borrow more. Even if the debt-service coverage ratio is higher than, but still too close to 1.0, then the borrower is considered to be vulnerable, as any minor decline in cash flow could render them unable to service their debt. For these reasons, the majority of Lenders in many cases require that the borrower maintain a minimum DSCR to qualify, and sometimes even a DSCR threshold while the loan is outstanding. In these cases, a lender will consider a borrower who falls below that minimum to be in default.
Sources:
- What is DSCR: Debt Service Coverage Ratio?
- DSCR Calculator
- Debt Service Coverage Ratio Formula and Example
- What are the DSCR Requirements for a Commercial Mortgage?
- DSCR vs. LTV for Commercial Loans
- How Commercial Lenders Calculate Net Operating Income (NOI) for DSCR
- DSCR vs. Debt Yield as a Measure of Loan Risk
- DSCR vs. Debt Yield Example
- Related Questions
- Get Financing
DSCR vs. LTV for Commercial Loans
In addition to DSCR, loan-to-value (LTV) ratio is one of the most important factors in the commercial mortgage approval process. In many cases, a loan will have an acceptable LTV (i.e. 75%) but will not have DSCR within a lender's acceptable range. In this case, the loan is considered "debt-service constrained." As a result, the loan amount must be reduced until the loan gets within the lender's approved range.
In some cases, lenders will look beyond the specific DSCR of the property, and instead, will look at something called global DSCR. Global DSCR looks at the property owner's personal income and expenses (or the income and expenses from their related business entities). This way, a lender can see a borrower has other sources of income that can bolster the project's net operating income in the case of financial distress. If a property owner does have other income sources, it increases the borrower's global DSCR and can allow them to get a larger loan. Global DSCR is often more important for small business commercial property loans, such as the SBA 504 or SBA 7(a) loan.
How Commercial Lenders Calculate Net Operating Income (NOI) for DSCR
In order to accurately estimate DSCR, borrowers first need to know the net operating income (NOI) of a property. However, when lenders calculate NOI, they also consider a project's:
For example, lender-calculated NOI can be significantly reduced when a building has a much lower vacancy than buildings in the area, but the NOI is still discounted based on average vacancy rates. Therefore, when a lender calculates a project's NOI for the purpose of a loan, it is often far less than the project's NOI in practice, resulting in a lower DSCR and a smaller loan amount.
DSCR vs. Debt Yield as a Measure of Loan Risk
Often, lenders use DSCR to assess risk in approving a new loan. However, some lenders prefer more stable measures of risk, such as the debt yield. Debt yield is calculated by dividing a project's NOI by its loan amount and multiplying it by 100 to achieve a percentage. When compared to DSCR, debt yield gives lenders more definitive timeline of recouping their funds in the event of a foreclosure.
DSCR vs. Debt Yield Example
For example, a property with an NOI of $1 million and a loan amount of $10 million would have a debt yield of 10%. This does not change regardless of the amount of the loan or the monthly payments. In contrast, DSCR can easily vary.
For instance, in the example above, if the loan was issued at a 6% interest rate with a 15 year amortization, the annual debt service would be approximately $1,012,000, giving us with a DSCR of 1.01x, which would not be accepted by most lenders. However, if we extended the amortization to 30 years, the annual debt service would be only $720,000, providing us with a DSCR of 1.38x, well within the acceptable range for most commercial lenders.
Right now, debt yield is mainly used by CMBS lenders, which experienced some of the most severe issues during the mortgage crisis of 2008. Debt yield is not yet commonly utilized by banks, life companies, and agency lenders, as they typically lend to less risky borrowers.