A typical commercial real estate lender receives dozens of new loan requests each month. As such, it is necessary to have a mechanism to filter through the deals to identify which ones have the best chance of being repaid. One of the ways that lenders do this is through the use of a metric called the Debt Service Coverage Ratio or “DSCR” for short.
In order to understand what the DSCR is and why it is so important, it is first necessary to understand the context in which it is used.
What is a Credit Policy?
Every lender’s approval/denial decisions are based on the contents of their credit policy, which is a document that outlines the metrics used to measure a loan’s risk and the acceptable levels for each. Among other things, a credit policy may cover:
Acceptable Property Types
Depending on the risk tolerance and strategic objectives of the lender, they may prefer certain property types over others. For example, most lenders like multifamily, office, and industrial property loans. But not all are willing to provide loans for hotels and restaurants. The credit policy outlines exactly which property types are acceptable and which ones aren’t.
Metrics Used to Measure Risk
Most credit policies contain an “approval box” for each property type that outlines which metrics are used to measure risk and the acceptable levels for each. The box typically includes metrics like Loan to Value or “LTV”, Debt Yield, and the Debt Service Coverage Ratio.
Individuals who have the authority to approve loans are called “Credit Officers” and the credit policy outlines who those individuals are and how much approval authority they have. Depending on the size of the lender and the dollar amount of the loan, it may take more than one individual to approve a request.
The larger point is this, the calculated Debt Service Coverage Ratio only matters relative to the credit policy of the lender evaluating the loan. If a property has a DSCR of 1.20X, it may seem good, but if the lender’s approval requirement is 1.25X, it is not good enough for approval. With that point established, a discussion of DSCR is the logical next step.
What is the Debt Service Coverage Ratio?
DSCR is a ratio that lenders use to measure a property’s Net Operating Income (NOI) relative to the payments on the requested loan. Mathematically, the formula used to calculate it looks like this:
While the equation is relatively straightforward, calculating the individual components of it can prove to be a bit tricky because it isn’t done consistently across lenders, particularly when it comes to NOI.
Net Operating Income is calculated as a property’s rental income minus all reasonable operating expenses, which typically include things like property insurance, taxes, utilities, and maintenance. Some lenders include depreciation in the calculation, others do not. Some prefer to use a modified NOI metric like Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) others stick with NOI. For these reasons, multiple lenders could look at the same property and come up with a slightly different numerator in the DSCR calculation.
The denominator in the equation, debt service, is relatively straightforward. It is calculated using the proposed loan’s amount, interest rate, and amortization period. However, it is important to note that the same time period should be used for both the numerator and denominator. If NOI is measured annually, debt service should also be calculated annually.
The result of the DSCR calculation is a decimal, usually expressed with an “X” to describe the multiple at which the property’s cash flow covers the required debt service. For example, a DSCR of 1.25X means that there is $1.25 in property NOI for every $1.00 in debt service.
Why the DSCR Matters
Fundamentally, the DSCR is a measure of risk in a loan transaction. Put another way, it is a metric that provides some insight into the likelihood that a borrower will ultimately default on the debt obligation.
A high DSCR, greater than 2.0X, means that a property can endure significant changes in the amount of Net Operating Income that it produces and still be able to meet its required debt obligations. So, the transaction poses less risk to the bank.
A low DSCR, 1.05 – 1.20, means that there is very little margin for change in a property’s Net Operating Income before its ability to service the debt is compromised. So, an unexpected vacancy or a change in rental rates could cause the DSCR to fall below 1.0X, which means that there is not enough income to make the annual debt payments, resulting in negative cash flow and red flags for the future.
As a general best practice, it is a good idea for borrowers and investors to calculate their own DSCR before applying for a loan so they have an idea of whether or not the loan request will meet the lender’s requirements. Again, the DSCR requirements may vary by property type and risk tolerance, so there is no “right” DSCR, but a minimum of 1.25X is a general target to aim for.
DSCR Calculation Example
To illustrate how the DSCR is calculated, consider the following example. Assume that a borrower is seeking a loan amount of $2,150,000 with an interest rate of 6% and an amortization period of 20 years. Using these parameters, the loan’s total debt service on an annual basis is ~$184,839. This is the denominator in the equation.
To obtain the numerator, it is necessary to create a pro forma financial projection for the property. For this example, it is summarized in the table below:
Again, annual net operating income is calculated as the property’s income less all reasonable operating expenses. From the table above, the result of this calculation can be seen for each year of the proforma. In year 1, the result is 1.24X, which is slightly below the typical 1.25X threshold. This does not necessarily automatically disqualify the loan because it is common for a borrower to use loan proceeds to acquire an underperforming property and implement a turnaround plan. For this reason, some lenders are willing to look at a “stabilized” DSCR, which may not occur until a few years into the holding period. By year two in the example above, DSCR has risen to 1.30X, which is above the target.
Final Notes on DSCR
Any time a discussion on DSCR comes up, it is usually referenced for a single property. But for borrowers and investors who have multiple real estate assets, a modified DSCR metric may be calculated as part of the bank loan review. The metric is called “Global DSCR” and it is a similar financial ratio, but it is measured at a portfolio level. The equation for calculating it is the same, Net Operating Income / Loan Payments, but the inputs come from an aggregation of the NOI produced by all properties in the portfolio, divided by an aggregation of all loan payments.
Global DSCR provides a lender with additional insight into the risk profile of the borrower because the DSCR for one property may be great, but if it is bad for other properties, it could cause the borrower to have to support them. And, any cash outlay used to support a property other than the one involved in the loan request weakens the borrower’s personal finances and their chances of loan approval.
Also, to protect against variations in DSCR, lenders may include a “covenant” in their loan agreements. Typically, the covenant states that the property’s NOI must be sufficient to maintain a DSCR of “XXX”, which is to be tested using financial statements quarterly/annually. In such cases, a dip below the required DSCR threshold can trigger a technical default on the loan, which is a negative for all parties.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
When working with lenders on our own loan requests, we always ask what the DSCR requirement is and calculate it on our own to gauge the maximum loan amount possible.
If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.