Debt Service Coverage Ratio (DSCR): Everything Borrowers Need to Know
Obtaining financing for your commercial real estate project requires an understanding of metrics like debt service coverage ratio (DSCR). Take a few minutes to read this overview from Assets America® and learn to master this important ratio.
What Is the Debt Service Coverage Ratio?
Debt service coverage ratio is a metric commonly used to underwrite income property loans. It measures how much cash flow is available for debt service (i.e., payments of principal and interest). The inability to meet your debt service obligations can result in default, foreclosure and potentially even bankruptcy.
How Do You Calculate the DSCR?
Let’s examine the ratio and its components. The formula is as follows:
DSCR = Net operating income / Total debt service
Components of DSCR
You calculate net operating income (NOI) by subtracting operating expenses (ignoring interest and tax payments) from revenue. In commercial real estate, interested parties commonly use DSCR for projects containing an income component. Often, you will come across a variation of the formula in which earnings before interest, taxes, depreciation and amortization (EBITDA) substitutes for NOI. EBITDA excludes non-cash expenses such as amortization and depreciation that don’t affect cash flow. Therefore, EBITDA is a better expression of the cash available to pay off debt.
Total debt service (TDS) is how much a company pays out for the period in principal, interest, and lease payments. If the company had a sinking fund – an account for accumulating money to repay a loan – it would also figure into the total debt service. TDS and NOI should refer to the same time period, usually one year.
Income Tax Adjustment
A loan’s interest cost, which is tax-deductible, affects total debt service. This means using interest directly will understate the borrower’s ability to meet its debt obligations. For a more precise formulation, the interest amount should be adjusted by multiplying it by (1 – tax rate). For example, if your interest rate on a loan is 10% and you are in the 21% tax bracket, your adjusted interest rate is (10% x (1 – 0.21)) or 7.9%. On a $5 million, interest-only loan, the annual debt service would be $500,000 before adjustment, but only $395,000 afterwards. Although this adjustment is theoretically superior, many lenders prefer the more conservative, unadjusted interest rate.
Debt Service Coverage Ratio Example
Suppose you wish to purchase a small to medium size office building for $14 million. You wish to put down $4 million in equity and finance the remainder through a 10-year, $10 million loan at an interest rate of 5.50%. The annual debt service requirement in the first year is .055 x $10 million = $550,000 in interest and $1 million in principal repayment, for a total of $1,550,000. You’ve carefully researched the building and are confident that you can extract an NOI of $2.3 million annually. Your DSCR therefore is $2.300M/$1.550M or 1.484. As we shall see, this should be more than sufficient to cover the loan obligation.
By the way, if you used the projected EBITDA of $2.5 million instead of the NOI of $2.3 million, your DSCR would be an even healthier 1.613.
If your tax-rate is 21 percent, the adjusted interest rate would be 5.50% x (1 – 0.21), or 4.345%, giving a first-year after-tax debt service of (0.04345 x $10,000,000) + $1M, or $1,434,500. This would further raise the DSCR to 1.603 (1.743 on an EBITDA basis), rounded to three decimal places.
What Is a Strong Debt Service Coverage Ratio?
Lenders want to know that you will pay back your loan on time and in full. Even if your loan is heavily collateralized, lenders do not want to resort to court proceedings to seize your collateral in lieu of loan payback. Legal proceedings are time-consuming and costly. Furthermore, the lender will have to liquidate the collateral, which presents its own set of problems.
Clearly, a debt service coverage ratio below 1.0 indicates a negative cash flow, meaning you would not be able to service your debt on time and in full without tapping other resources. Most lenders do not welcome a negative cash flow, but if you can show you have additional funds available, you might be able to swing the deal. Most likely, however, the lender would balk or insist on a substantially larger equity contribution. Experts consider a DSCR up to 1.1 to be shaky, because it leaves little room for error in estimating NOI or EBITDA. Many lenders want to see a DSCR of at least 1.2 when considering a commercial loan application. However, Assets America® might be able to secure a loan with a DSCR between 1.0 and 1.2. Of course, this depends on your unique and specific circumstances and other compensating factors.
Economic conditions can factor into a lender’s interpretation of DSCR. In an expanding economy, lenders tend to soften their underwriting requirements, partially in the belief that the borrower’s NOI will increase over the term of the loan. Of course, carried to an extreme, you wind up with 2008, so one should not assume that lenders will fully revert to the practices that led to that incendiary crisis.
Debt Service Coverage Ratio vs Debt Yield Ratio
Experts define debt yield ratio as NOI divided by loan amount (NOI / LA). For example, a debt yield of 23% would result from a property earning an NOI of $2.3 million on a loan amount of $10 million ($10M). The debt yield is a measure of leverage, and therefore lower yields indicate higher risk. The benefit of a debt yield ratio is that it isn’t inflated by high amortization periods, low-interest rates or low market capitalization rates. A lender will usually set a minimum debt yield ratio on the loans it makes, such as 10%. If that was the case in our example, the lender would have further evidence to approve the loan application.
Improving Your Debt Service Coverage Ratio
There are several ways to improve your debt service coverage ratio:
- Increase Amortization Period: If your DSCR is too low for a 10-year loan, consider a 15-year loan. This lowers you monthly principal payments and raises your DSCR (but increases the total cost of the loan).
- Take an Interest Only Loan: For short-term loans, such as construction loans, taking out an interest-only loan relieves you of principal payments and therefore boosts your DSCR. However, a lender may still include principal payments as part of their underwriting DSCR calculations.
- Decrease Leverage: Putting down a larger equity stake will increase your DSCR and demonstrates your commitment to the project. Lenders always like to see more skin in the game.
- Cut Expenses: You can increase NOI by cutting property expenses. You might forego or charge extra for certain services, find lower-cost suppliers, replace high-salary employees with lower-salary employees, and increase the speed of evictions.
- Increase revenues: Part of your real estate loan might go towards renovating a property in a way that allows you to charge higher rents and decrease vacancies. This increases NOI and DSCR–a win-win.
If you can’t raise your debt service coverage ratio enough to satisfy your lender, you might need a new lender. Turn to Assets America® for loans of $5 million and beyond. We have an extensive network of funding sources including banks, institutional and private money lenders along with a wide range of underwriting standards. We can show ways to improve your DSCR and dramatically increase your chances for successfully obtaining a loan. If you want safety, and surety of execution, choose Assets America® for all of your commercial financing needs.
Looking for More Information?
For more information on commercial mortgages and commercial financing, check out these overviews of Closing Costs, Refinancing, and Credit. You may also wish to use our Mortgage Checklist and find out which loan type is best for you. Furthermore, you may be interested in Multifamily Loans, Hotel Loans, and Balloon Mortgages.