Debt Service Coverage Ratio
Debt Service Coverage Ratio, or DSCR, is a measurement of an entity’s cash flow vs. its debt obligations.
What Is a Debt Service Coverage Ratio?
A debt service coverage ratio (DSCR), also known as a debt coverage ratio (DCR), represents the ratio of cash available for servicing debt (typically principal and interest mortgage payments). DSCR is commonly scrutinized by lenders when measuring a borrower's ability to produce enough funds to completely cover their debt obligations. The higher the DSCR, the less risk for the lender, and thus the easier it is to obtain financing. For example, while financing for many multifamily apartment properties may require a minimum DSCR of 1.20x to qualify for funding, riskier property types —such as self-storage facilities — may need a DSCR of at least 1.40x or 1.50x in order to qualify.
DSCR is important in commercial real estate finance for a variety of reasons. As mentioned, DSCR is critical in cash flow analysis for a prospective loan for commercial real estate: The ratio is consistently utilized to compare a target property's net operating income to the borrowing entity’s target mortgage debt service on an annual basis. This measurement helps lenders to ensure that a borrower will be able to pay the loan back, making it an invaluable risk calculation metric. Lenders aside, commercial real estate investors looking to purchase an income-producing property often analyze their debt service coverage ratio in order to gain a better understanding of the financial implications of their prospective purchase.
How to Calculate Debt Service Coverage Ratio
As important and informational as the debt service coverage ratio is in commercial finance, the calculation of DSCR is actually quite simple. In order to calculate the DSCR for a commercial property, you would simply divide the property’s net operating income by the total value of its debt obligations. It is important to remember that for a DSCR calculation, net operating income (NOI) is calculated using EBITDA (earnings before interest, tax, depreciation, and amortization).
Debt Service Coverage Ratio Formula
DSCR = Net Operating Income ÷ Annual Debt Service
Debt Service Coverage Ratio Calculator
Regular DSCR vs. Global DSCR
For small business commercial property loans and some smaller multifamily loans, many lenders opt to take a global DSCR into account rather than the standard debt service coverage ratio. Global DSCR, unlike its counterpart, includes a borrower’s personal income and debts in addition to the property’s income and debts. Depending on the personal financial strength of the borrower in question, this can either be very beneficial, or very frustrating.
To better illustrate how global DSCR can affect financing, consider the following. An investor with a high income and few personal debts may see that their global DSCR is much higher, and much more desirable to lenders, than their property’s or business’s DSCR, while an investor with a low income and a mountain of personal debt would most likely see their global DSCR greatly undercut the property’s DSCR using this approach.
Related Questions
What is a debt service coverage ratio?
A debt service coverage ratio, also known as a debt coverage ratio or DSCR, is the ratio of cash available for what's known as servicing debt (generally principal and interest mortgage payments). This benchmark is commonly used in measuring an entity's — usually a person or a corporation’s — ability to produce enough funds to completely cover their debt payments, including payments delegated to leases. The higher the ratio gets, the easier it becomes for that entity to obtain financing.
When applying for an SBA Express loan, lenders almost always check your "DSCR." For those who are unfamiliar with the term, debt service coverage ratio (DSCR) refers to the borrower's ability to repay debt obligations. Debt service is the money needed to cover both interest and principal in a payment period. The ratio is a formula that divides the net operating income of a business by the total debt service amount:
DSCR = Net Operating Income / Total Debt Service
So, a business with a DSCR of less than 1 does not have sufficient funds to pay back debt obligations, while a business with a DSCR of greater than 1 does.
How is debt service coverage ratio calculated?
In order to calculate a debt service coverage ratio, those handling the calculation divide the net operating income (referred to as NOI) by the entity's annual debt service. To provide an example, the formula for calculating the debt service coverage ratio looks like this:
DSCR = Net Operating Income ÷ Annual Debt Service
DSCR = $845,000 ÷ $758,475
DSCR = 1.10x
The formula shows that the cash flow generated by the target property will end up covering the new commercial loan payments by 1.10x. This figure is considered lower than many commercial mortgage lenders require. Most lenders require a minimum DSCR of 1.20x.
Debt service coverage ratios of at least 1.0x are considered to be in the breakeven range. At the same time, any figures below 1.0x would be a net operating loss for the prospective debt structure taken on by the entity.
What is a good debt service coverage ratio?
The most important thing to remember is that a “good” debt service coverage ratio (DSCR) depends wholly on the requirements of the lender for the loan product in question. A widely accepted standard, however, is that a DSCR above 1.25 is often considered “strong,” and DSCR ratios below 1.00 are decent indicators that the borrower may be facing some financial hardships. This is because a DSCR of less than 1.00 reflects a negative cash flow, which, to lenders means that the borrower will be unable to cover the costs of their debt obligations without needing to borrow more.
In practice, a DSCR of 0.93 equates to the borrower only having sufficient income to cover 93% of their annual debt obligations. To a lender, this represents extremely high risk, as this metric basically shows that the borrower will need additional income to be able to make payments towards their debts. Even then, If the debt-service coverage ratio is higher than, but still too close to 1.0, then the borrower is considered to be vulnerable, as any minor decline in cash flow could render them unable to service their debt.
For these reasons, the majority of Lenders in many cases require that the borrower maintain a minimum DSCR to qualify, and sometimes even a DSCR threshold while the loan is outstanding. In these cases, a lender will consider a borrower who falls below that minimum to be in default.
In summary, a good debt service coverage ratio is generally considered to be above 1.25, while a ratio below 1.00 is an indicator of potential financial hardship. Lenders may require a minimum DSCR to qualify for a loan, and may consider a borrower in default if they fall below that minimum.
What is the difference between debt service coverage ratio and debt to income ratio?
The debt service coverage ratio (DSCR) is the ratio of cash available for servicing debt (generally principal and interest mortgage payments). This benchmark is commonly used in measuring an entity's ability to produce enough funds to completely cover their debt payments, including payments delegated to leases. The higher the ratio gets, the easier it becomes for that entity to obtain financing.
The debt to income ratio (DTI) is the ratio of a borrower's total monthly debt payments to their gross monthly income. This ratio is used to determine a borrower's ability to make their monthly payments on time. The higher the ratio, the more likely it is that the borrower will default on their loan.
The main difference between the two is that the DSCR is used to measure an entity's ability to produce enough funds to cover their debt payments, while the DTI is used to measure a borrower's ability to make their monthly payments on time.
What are the benefits of having a high debt service coverage ratio?
Having a high debt service coverage ratio (DSCR) has several benefits. A high DSCR indicates that a borrower has the ability to generate enough cash flow to cover their loan payments. This makes it easier for them to obtain financing. A high DSCR also helps lenders understand the borrower's ability to sustain and pay off debts for a commercial or multifamily property. Additionally, a high DSCR can help people who are interested in purchasing an apartment building understand more about their prospective purchase.
What are the risks of having a low debt service coverage ratio?
Having a low debt service coverage ratio (DSCR) can be a major risk for borrowers. A DSCR of less than 1.00 reflects a negative cash flow, which, to lenders means that the borrower will be unable to cover the costs of their debt obligations without needing to borrow more. In practice, a DSCR of 0.93 equates to the borrower only having sufficient income to cover 93% of their annual debt obligations. To a lender, this represents extremely high risk, as this metric basically shows that the borrower will need additional income to be able to make payments towards their debts. Even then, If the debt-service coverage ratio is higher than, but still too close to 1.0, then the borrower is considered to be vulnerable, as any minor decline in cash flow could render them unable to service their debt. For these reasons, the majority of Lenders in many cases require that the borrower maintain a minimum DSCR to qualify, and sometimes even a DSCR threshold while the loan is outstanding. In these cases, a lender will consider a borrower who falls below that minimum to be in default.
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