Resources



Debt Service Coverage Ratio (DSCR) in Real Estate

Obtaining financing for your commercial real estate project requires an understanding of metrics like debt service coverage ratio (DSCR). In this article, we discuss “What is the debt service coverage ratio?” We also examine how to calculate the DSCR, including an example calculation and a tutorial video for Excel. Furthermore, we examine DSCR components for real estate, tax issues, healthy ratios, the debt yield ratio, how to improve your DSCR, and helpful resources. Take a few minutes to read this overview from Assets America® and learn to master this important metric for commercial real estate.

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.

Apply For Financing

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

Businessman and businesswoman using digital tablet for the debt service coverage ratio formula

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, you can adjust the interest amount 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. Accordingly, your DSCR 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.

Video: How to Calculate Debt Service Coverage Ratio – Excel Tutorial

What Is a Strong Debt Service Coverage Ratio?

Ultimately, 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. In other words, 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, when carried to an extreme, this trend can result in situations like the 2008 financial crisis. Accordingly, 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 the 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:

  1. Increase Amortization Period: If your DSCR is too low for a 10-year loan, consider a 15-year loan. This lowers your monthly principal payments and raises your DSCR. However, it increases the total cost of the loan.
  2. 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.
  3. Decrease Leverage: Putting down a larger equity stake increases your DSCR and demonstrates your commitment to the project. Lenders always like to see more skin in the game.
  4. 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.
  5. Cut Expenses: You can increase NOI by cutting property expenses. For example, you can (1) forego or charge extra for certain services, (2) find lower-cost suppliers, (3) replace high-salary employees with lower-salary employees, and (4) increase the speed of evictions.
  •  

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 $10 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.

Related Articles



Testimonials

Eric D.
Pleasure to work with and extremely knowledgeable

Ronny was a pleasure to work with and is extremely knowledgeable. His hard work was never ending until the job was done. They handled a complex lease and guided us through entire process, including the paperwork. Not to mention a below market lease rate and more than all the features we needed in a site. We later used Assets America for a unique equipment financing deal where once again Ronny and team exceeded our expectations and our timeline. Thank you to Assets America for your highly professional service!

exp MFGroup
Great experience with Assets America

Great experience with Assets America. Fast turn around. Had a lender in place in 30 minutes looking to do the deal. Totally amazing. Highly recommend them to anyone looking for financing. Ronny is fantastic. Give them a call if the deal makes sense they can get it funded. Referring all our clients.

William P.
Assets America guided us every step of the way

Assets America guided us every step of the way in finding and leasing our large industrial building with attached offices. They handled all of the complex lease negotiations and contractual paperwork. Ultimately, we received exactly the space we needed along with a lower than market per square foot pricing, lease length and end of term options we requested. In addition to the real estate lease, Assets America utilized their decades-long financial expertise to negotiate fantastic rates and terms on our large and very unique multimillion dollar equipment purchase/lease. We were thankful for how promptly and consistently they kept us informed and up to date on each step of our journey. They were always available to answer each and every one of our questions. Overall, they provided my team with a fantastic and highly professional service!

Bob B.
The company is very capable, I would recommend Assets America

Assets America was responsible for arranging financing for two of my multi million dollar commercial projects. At the time of financing, it was extremely difficult to obtain bank financing for commercial real estate. Not only was Assets America successful, they were able to obtain an interest rate lower than going rates. The company is very capable, I would recommend Assets America to any company requiring commercial financing.

Ricardo L.
Assets America was incredibly helpful and professional

Assets America was incredibly helpful and professional in assisting us in purchasing our property. It was great to have such knowledgeable and super-experienced, licensed pros in our corner, pros upon which we could fully rely. They helped and successfully guided us to beat out 9 other competing offers! They were excellent at communicating with us at all times and they were extremely responsive. Having them on our team meant that we could always receive truthful, timely and accurate answers to our questions. We would most definitely utilize their services again and again for all of our real estate needs.

HMG R&D
Assets America is a great company to work with

Assets America is a great company to work with. No hassles. Recommend them to everyone. Professional, fast response time and definitely gets the job done.

DAC Team
Great experience

Ronny at Assets America has been invaluable to us and definitely is tops in his field. Great experience. Would refer them to all our business associates.

MF Group
We were very pleased with Assets America’s expertise

We were very pleased with Assets America’s expertise and prompt response to our inquiry. They were very straight forward with us and helped a great deal. We referred them to all our business associates.

Manny C.
Worked with this company for decades

I’ve worked with this company for decades. They are reputable, knowledgeable, and ethical with proven results. I highly recommend them to anyone needing commercial financing.

David B.
Top-notch professional

Ronny was incredibly adept and responsive – top-notch professional who arranged impressive term sheets.

Monte M.
Assets America helped us survive a very difficult time

Assets America helped us survive a very difficult time and we most definitely give them 5 stars!

Brent G.
Gave me direction to go

Ronny was very friendly and though we were unable to make something happen at the moment he gave me some direction to go.

Allan E.
Highly recommend them for any type of commercial financing

My business partner and I were looking to purchase a retail shopping center in southern California.  We sought out the services of Ronny, CFO of Assets America.  Ronny found us several commercial properties which met our desired needs.  We chose the property we liked best, and Ronny went to work. He negotiated very aggressively on our behalf. We came to terms with the Seller, entered into a purchase agreement and opened escrow.  Additionally, we needed 80 percent financing on our multimillion-dollar purchase.  Assets America also handled the commercial loan for us.  They were our One-Stop-Shop. They obtained fantastic, low, fixed rate insurance money for us.  So, Assets America handled both the sale and the loan for us and successfully closed our escrow within the time frame stated in the purchase agreement.  Ronny did and performed exactly as he said he would. Ronny and his company are true professionals.  In this day and age, it’s especially rare and wonderful to work with a person who actually does what he says he will do.  We recommend them to anyone needing any type of commercial real estate transaction and we further highly recommend them for any type of commercial financing.  They were diligent and forthright on both accounts and brought our deal to a successful closing.