What is DSCR (Debt Service Coverage Ratio) in Real Estate?
DSCR Stands for Debt Service Coverage Ratio and describes the relationship between a property’s annual net operating income (NOI) and its annual mortgage service. The mortgage debt service will include both the principal and interest payments. So, if a property has an NOI of $200,000 and an annual mortgage debt service of $150,000 then the DSCR would be 1.33.
Commercial lenders take the DSCR of a property into account to calculate how much they believe a business can afford to borrow. The DSCR gives a strong indication of how much cash flow a property generates, and this is a useful metric for calculating the affordability of a loan.
Most lenders have a maximum Loan to Value (LTV) that they will offer, but with commercial mortgages, the DSCR is often the limiting factor and a borrower may not be offered the maximum LTV because the income that the property generates is insufficient.
Loan to Value Ratio Explained
If you have ever taken out a residential mortgage you may be familiar with the Loan To Value (LTV) Ratio. This is the value of the property compared with the value of the loan that the borrower wishes to take out. For example, if a property has a value of $500,000 and the borrower wants to take out a mortgage of $400,000 then that is a LTV of 80%.
Commercial lending is considered high risk, and this means that lenders typically offer a maximum LTV of somewhere between 70% to 80%. This means that you would need to find some other way of paying for the remaining 20% to 30%. An established business with demonstrably good cash flow in a low-risk niche is more likely to get a higher LTV than a newer business or one that is in a ‘risky’ niche.
The LTV is just one factor that is taken into account, however. If the business has a poor DSCR, then the lender may limit the LTV because of that. They will reduce the LTV until their required DSCR is met. When this happens, the loan dollars are considered to be “debt service constrained”. Lenders will often take into account the cap rate when considering their DSCR and LTV requirements to ensure that the business that wants the loan is using the property well.
What is the Cap Rate?
The cap rate, or capitalization rate of a business is the net operating income divided by the current market value of the property.
This is usually expressed as a percentage and shows the likely rate of return on the investment. A higher cap rate means a better investment.
Note that the cap rate is based on net operating income, not gross. This means that when calculating the cap rate you should take into account operating expenses such as maintenance costs, taxes on the property, etc. Depreciation is not considered.
The cap rate is a good “off the cuff” measure of the worth of a property, but it is not the only measure that an investor should use.
Lenders take the cap rate into account when considering the DSCR and LTV that they will allow for a property. For example, if a property has a cap rate of 5%, which would make it a decent investment in many people’s eyes, then the lender may expect a 40% deposit, creating a LTV of 60%, so that the DSCR is acceptable in their eyes. Some very discerning investors look for cap rates of 10 percent or even higher, but it can be hard to find available properties with that kind of income-generating possibility in many cities.
What is a Good DSCR Ratio
The DSCR can vary massively depending on the type of property that you are looking to invest in and the nature of your business.
In general, however, a DSCR of 1.25 is considered acceptable by most lenders. Higher is better. If your DSCR is 1.5 then that means you have 50% more income than required to cover your debts. If your DSCR is 1.0, then you are making enough to cover your expenses, but you are not making a profit. DSCRs that are lower than 1 mean that you are currently running at a loss.
Lenders will not consider a company that is making a loss. You are highly unlikely to be able to get a loan if you are breaking even, either, because one bad month could take you from ‘breaking even’ to making a loss. Most lenders want to see that you have some extra income that can act as a buffer for those periods where your cash flow fluctuates.
Each lender has their own policies, and some lenders may expect better DSCRs than others.
Note that many lenders re-evaluate a company’s DSCR every year and will base interest rate calculations on changes to your DSCR. Some lenders may even require you to pay off your loan in full on an accelerated timescale if you fail to stay above a certain DSCR. For this reason, it is important to read any loan agreements carefully and make sure that you fully understand the DSCR requirements and exactly how your lender of choice calculates the DSCR.
Can You Afford a Commercial Property Loan?
The DSCR and LTV are two incredibly useful metrics. If you have been unable to save up for a deposit on a property then how can you be confident that you will be able to service the loan in the long term?
The DSCR is a useful guide to how much your business is making and whether the business is right for that size of property. Remember that the DSCR is based on the debt payments, not the value of the property so if you are able to put down a larger deposit and get a lower interest rate that will lower the monthly repayments and increase the DSCR.
You can work out your target borrowing amount by dividing your Net Operating Income by your desired DSCR. So, if your NOI is $400,000 and your desired DSCR is 1.25, that gives you a borrowing amount of $320,000. Get your accountant or financial advisor to play with the figures and see how they work for you.