What is DSCR?
The Debt Service Coverage Ratio (DSCR) measures if the income generated by a commercial property is sufficient to fulfill its annual debt burden.
The debt service coverage ratio (DSCR) is calculated by dividing the net operating income (NOI) of an property by its annual debt service, which includes interest payments and principal amortization.
- DSCR is an abbreviation for “Debt Service Coverage Ratio”
- The debt service coverage ratio (DSCR) is a credit metric used to determine if a commercial rental property generates enough income to meet its annual debt service.
- The formula to calculate DSCR divides the net operating income (NOI) of a property by its annual debt service, which includes interest payments and principal amortization.
- A higher DSCR implies less credit risk, while a lower DSCR suggests more credit risk.
- The minimum DSCR requirement set by most commercial lenders is 1.25x.
Table of Contents
How to Calculate DSCR
The debt service coverage ratio (DSCR) measures the credit risk and debt capacity of a commercial property by comparing its income potential to its annual debt service requirements.
The debt service coverage ratio (DSCR) offers practical insights into a property’s credit risk as of the present date, and whether its cash flows can handle the debt burden (or if the borrower is at risk of default).
When analyzing the financial viability of a property, the DSCR is one of the fundamental credit metrics that real estate lenders rely on to assess the risk attributable to the financing of a particular property and estimate the likelihood of timely debt repayment, per the lending agreement.
The DSCR facilitates informed decisions by commercial real estate (CRE) investors and institutional lenders, because the ratio confirms whether the underlying property can produce enough income to cover its annual debt service.
From the perspective of lenders, the factor that dictates if their target yield on the financing arrangement is met is the receipt of on-time payments without the borrower defaulting and becoming insolvent.
The steps to calculate the debt service coverage ratio (DSCR) are as follows.
- Calculate the Net Operating Income (NOI) of the Property
- Determine the Annual Debt Service Obligation (Principal Amortization + Interest Expense)
- Divide the NOI of the Property by the Annual Debt Service
- Multiply by 100 to Convert the DSCR from Decimal Notation to Percentage Form
DSCR Formula
The formula to calculate the debt service coverage ratio (DSCR) divides the net operating income (NOI) of a property by its annual debt service.
Where:
- Net Operating Income (NOI) → The NOI metric is used in the real estate industry to analyze the operating profitability of properties. NOI is the total income generated by a property – inclusive of rental income and ancillary income – minus direct operating expenses such as property management fees, maintenance costs, property taxes, and property insurance.
- Annual Debt Service → The annual debt service is the total financing obligations that a property must fulfill, most notably the mandatory principal repayments on a mortgage loan and the periodic interest payments.
The formula to calculate the net operating income (NOI) of a property is as follows.
What is a Good DSCR?
The debt service coverage ratio (DSCR) is a practical tool for investors and lenders to analyze the credit profile of a property based on its income potential, which determines its estimated debt capacity.
- Higher DSCR → A higher DSCR implies that the property’s income is more than sufficient to meet its annual financial obligations comfortably (i.e. sufficient “cushion” to prevent defaulting on the loan even if the global economy unexpectedly enters a recession).
- Lower DSCR → In contrast, a lower DSCR coincides with greater credit risk (and represents a potential “red flag”), where the lender must perform rigorous diligence in anticipation of the worst-case scenario.
Real Estate Underwriting Parameters:
- DSCR = 1.0x → NOI = Annual Debt Service (Breakeven Point)
- DSCR > 1.0x → NOI > Annual Debt Service (Sufficient Income)
- DSCR < 1.0x → NOI < Annual Debt Service (Insufficient Income)
The minimum debt service coverage ratio (DSCR) is widely recognized as 1.25x by commercial real estate lenders.
The more excess net operating income (NOI) the property generates relative to the annual debt service, the more favorable lenders will perceive the loan application and financing request, since the risk of default is far lower.
Unless the probability of recovering the original proceeds is near certain, most commercial lenders are unlikely to approve the request for financing.
Hence, most risk-averse lenders require collateral as part of their loan financing agreement to protect their downside risk. In fact, the lender might require more collateral and impose strict covenants to mitigate the risk even further to consider proceeding with the financing arrangement.
However, the range for the minimum DSCR required by lenders tends to fluctuate based on different factors, such as the lender’s current risk appetite, the type of property pledged as collateral, the current conditions of the real estate market, and the near-term economic outlook.
