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The debt service
coverage ratio is
one of the least
understood
underwriting
requirements for new
and even seasoned
commercial real
estate investors.
Briefly, the debt
service coverage
ration simply
compares the subject
property's net
operating income to
the proposed
mortgage debt
service (on an
annual basis). The
lender wants to
ensure there is
sufficient cash flow
to cover the new
mortgage debt, and
then some.
Learn more about the
debt service
coverage ratio
(DSCR).
It's important to
understand the
concept and math
behind the DSCR if
you are calculating
your own cash flow
analysis for a
prospective
commercial loan or
apartment loan,
whether it's a
purchase or
refinance. If the
property is
operating more
efficiently than
comparable
properties (due to
self management, not
keeping up with R&M,
etc.), or not
including a minimum
vacancy percentage,
both the underwriter
and appraiser will
use a vacancy factor
and bring expenses
inline with market -
which reduces the
NOI thereby lowering
the DSCR and loan
amount.
Below is a basic
example of how a
commercial
lender calculates
the DSCR for a
commercial mortgage. The lender
holdbacks are
highlighted in blue,
remember these are
not actual expenses,
but are
deducted from the
property's gross
income for
underwriting
purposes. The example
below assumes a 75
unit property
multifamily
property. Be sure to
use gross potential
rents (GPR) and not
actual collected
rents for rental
income. Why? Because
an underwriter and
appraiser will use
GPR and apply a
vacancy percentage.
If you aren't using
GPR and using a
vacancy percentage
you will essentially
be double counting
vacancy (assuming
you had a vacancy
during the year).
Additionally, if
rents have increased
you will want to be
sure to use the most
current rents in
your analysis and
not the previously
lower rents.
|
Income |
|
|
Gross
Potential Rents |
$1,000,000 |
|
Other Income |
|
|
Total Annual
Gross Income |
$1,000,000 |
|
Less 5% Vacancy
& Collection
Loss |
$50,000 |
|
Effective Gross
Income: |
$950,000 |
|
|
|
|
Expenses |
|
|
Real Estate
Taxes |
$15,000 |
|
Property Insurance |
$5,000 |
|
Repairs &
Maintenance |
$5,000 |
|
Pest Control |
$5,000 |
|
Janitorial |
$5,000 |
|
Utilities |
$5,000 |
|
5% Off Site Management
Reserve |
$50,000 |
|
Replacement
Reserves
Estimated at
$200 Per Unit @
75 Units |
$15,000 |
|
Total Operating
Expenses: |
$105,000 |
|
|
|
|
Net Operating
Income (NOI)
|
$845,000 |
Now that we have
calculated the NOI, we
must calculate the
annual
debt service for the
property. The annual
debt service is the
simply the total amount
of principal and
interest payments made
over a 12 month period.
Taxes and insurance are
not included in this
calculation as
they are accounted for
in the expenses of the
property.
To
calculate the debt
service coverage ratio,
simply divide the net
operating income (NOI)
by the annual debt.
Commercial Loan Size:
$10,000,000
Interest Rate: 6.5%
Term: 30 Years
Annual Payments (Debt
Service) = $758,475
Net Operating Income
(NOI) = $845,000
Now we can calculate the
DSCR:
DSCR = Net Operating
Income / Annual Debt
Service
(NOI) = $845,000
Total Debt Service
= $758,475
DSCR = 1.10 ($845,000 /
$758,475)
What this example tells
us is that the cash flow
generated by the
property will cover the
new commercial loan
payment by 1.10x. This
is generally lower than
most commercial mortgage
lenders require. Most
lenders will require a
minimum DSCR of 1.20x.
If a DSCR is 1.0x, this
is called breakeven, and
a DSCR below 1.0x would
signal a net operating
loss based on the
proposed debt structure.
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