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.
- The DSCR is a credit metric used to determine if a commercial 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 around 1.25x.
How to Calculate DSCR?
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
The formula to calculate the debt service coverage ratio (DSCR) divides the net operating income (NOI) of a property by its annual debt service.
- 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, on the other hand, 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 given 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 entered 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)
Generally, 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.
What Does a DSCR of 1.25x Mean?
Suppose the DSCR of a commercial real estate (CRE) building is 1.25x – i.e. the minimum threshold of most investors and lenders alike.
So, what is the meaning of a 1.25x debt service coverage ratio (DSCR)?
Since the DSCR demonstrates the “extra cushion”, or lack thereof, in the net operating income (NOI) of a property compared to its annual debt service, a 1.25x DSCR implies the NOI is 125% of the annual debt payments.
Therefore, the property has 25% of excess NOI, which can act as a buffer for unexpected underperformance.
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Commercial Real Estate Property Assumptions (CRE)
Suppose a commercial real estate (CRE) investor is requesting a 30-year loan from a bank lender to purchase an office building.
If approved, the financing transaction would close at the end of 2023.
The pro forma financial data of the commercial building at stabilization are as follows.
|Selected Financial Data|
|($ in thousands)||2023E|
|Gross Potential Rent (GPR)||$1,000|
|(+) Ancillary Income||200|
|Potential Gross Income (PGI)||$1,200|
|(–) Vacancy and Credit Losses (@ 5.0%)||(60)|
|Effective Gross Income (EGI)||$1,140|
|(–) Total Operating Expenses||(500)|
|Net Operating Income (NOI)||$640|
2. DSCR Calculation Example
In the next section, we’ll start by listing the financing assumptions.
The interest rate pricing on the commercial loan is 6.0% with a term of 30 years.
- Annual Interest Rate (%) = 6.0%
- Loan Term = 30 Years
By dividing the commercial property’s NOI by the debt service – which we can determine using the PMT function in Excel – we can set the size of the loan appropriately.
3. DSCR Loan Sizing Analysis Example
If the commercial loan is sized at $3.52 million, the debt service coverage ratio (DSCR) is 2.50x, which is an optimal DSCR that implies “excess” income to cover the annual debt burden.
- Debt Service Coverage Ratio (DSCR) = 2.50x
The commercial property is expected to generate NOI in excess of two and a half “turns” of the annual debt service.
Commercial lenders prefer a higher DSCR, because that implies a greater margin of safety (i.e. “more room for error”).
A DSCR of 2.50x affirms the notion that the property generates enough income to handle the current debt burden without the risk of default.
Therefore, this particular request for a commercial loan is very likely to receive approval from lenders, since the property’s debt service coverage ratio (DSCR) is considerably outsized relative to its annual debt service.
Of course, the lending decision is not based on the debt service coverage ratio (DSCR). The commercial lender will also use other credit ratios to better understand the risk of the borrowing and size the loan appropriately as part of the underwriting process.