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What is Debt Service Coverage Ratio in Commercial Real Estate?

[Updated: Mar 02, 2021 ] Oct 08, 2019 by Liz Brumer
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If you plan on investing in commercial real estate, you'll likely get financing from a bank or lender. The loan underwriting process differs greatly from a residential loan, including the metrics lenders use to determine if they'll loan to you or not.

One of the most important metrics used when applying for a commercial loan is the debt service coverage ratio (DSCR). Let's take a look at what DSCR is, how to calculate debt service coverage ratio and why it's an important part of investing in commercial real estate.

What is debt service coverage ratio (DSCR) in commercial real estate?

The debt service coverage ratio examines the borrower's ability to repay the debt obligation based on the property's income and performance. A commercial lender will then use the DSCR to determine the maximum loan amount or whether the property can sustain the debt it is incurring.

How to calculate debt service coverage ratio (DSCR)

The DSCR calculation is rather simple. A business's DSCR is calculated by taking the property's annual net operating income (NOI) and dividing it by the property's annual debt payment. The DSCR is typically shown as a number followed by x.

Debt Service Coverage Ratio Formula

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For example, if you're looking at purchasing an investment property that produces $500,000 in annual net operating income and the debt service is $410,000 a year, the DSCR would be 1.22x. If a property has a DSCR of 1.22x, it means the asset can cover its debt 1.22 times in a given year.

If the DSCR is less than 1.0x, it indicates that the property doesn't have enough income to support its current debt obligations. The higher the DSCR, the more secure the lender's position, because the NOI is higher in proportion to the debt service.

What is the ideal DSCR?

The minimum DSCR varies from lender to lender and by asset type, but in general, most lenders look for a DSCR in the 1.25x–1.5x range. This means that, at a minimum, the asset can produce an additional 25% of additional income after all debt payment.

Debt service coverage ratios change as the property's performance changes. For example, if you bought a property that had an NOI of $150,000 upon acquisition and your annual debt service was $130,000, the DSCR would be 1.15x. However, if you can lower costs and increase rents to market rates, thereby growing the NOI to $180,000 by year two, the DSCR would increase to 1.38x.

If the investment is underperforming but there's the potential to increase cash flow through increasing rents or units, the lending institution may approve the loan even though the DSCR is below the minimum threshold.

Why knowing your property's DSCR is important

Since the debt service coverage ratio is one of the most important metrics used in commercial lending, it's important for the borrower to know the minimum qualifications required by a lending institution. This can help you adjust your offer to produce the appropriate DSCR and ensure you're not overleveraging the property in your effort to increase the likelihood of getting a loan approved.

While the debt service coverage ratio isn't the only metric used when applying for a commercial loan, it's a crucial part of getting a loan approved. By understanding how the metric works and how it relates to the asset's performance, you can be more informed and prepared when buying a commercial property.

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