Nearly all commercial real estate transactions are financed with some combination of debt and equity. The equity comes from the property owner and/or their investors, while the debt comes from a bank or non-bank lender. The exact mix varies by transaction, but equity typically represents 15%–25% of the purchase price, with debt covering the remaining 75%–85%.
One of the major benefits of commercial real estate investing is that debt is widely available for most property types at generally favorable terms. However, those terms vary significantly by lender and asset class, making it critical for investors to understand how lenders assess risk. One of the most important—and often misunderstood—metrics in that process is the Debt Service Coverage Ratio (DSCR).
Lenders receive dozens of loan requests each month, and DSCR serves as a practical screening tool to determine which transactions have the highest likelihood of being repaid. In that sense, the debt service ratio in real estate is less about theoretical performance and more about downside protection.
What is the Debt Service Coverage Ratio?
The Debt Service Coverage Ratio measures a property’s Net Operating Income (NOI) relative to its required annual loan payments. It is typically expressed as a multiple, such as 1.20X or 1.25X, indicating how many dollars of cash flow are available for each dollar of debt service.
From a risk perspective:
- A higher DSCR indicates more margin for error and lower lender risk.
- A lower DSCR signals tighter cash flow and higher sensitivity to vacancies, rent declines, or expense increases.
- A DSCR below 1.0X means the property does not generate enough income to cover its debt obligations—an immediate red flag for most lenders.
How is the Debt Service Coverage Ratio Calculated?
The formula itself is straightforward:
Debt Service Coverage Ratio = Net Operating Income ÷ Annual Debt Service
Where the complexity arises is in how the inputs are defined.
Net Operating Income (NOI)
Broadly, NOI is calculated as a property’s income—primarily rent—minus all reasonably necessary operating expenses, such as:
- Property taxes
- Insurance
- Utilities
- Maintenance and repairs
However, lenders do not calculate NOI uniformly. Some use a modified NOI or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), while others apply their own standardized adjustments. One common point of inconsistency is depreciation, which is a non-cash accounting expense. Some lenders include it in total expenses, while others exclude it. That distinction alone can be the difference between loan approval and decline.
Annual Debt Service
Annual debt service represents the contractually required loan payments over a one-year period, based on:
- Loan amount
- Interest rate
- Amortization period
- Loan term
It is important that both NOI and debt service are measured over the same time frame—typically annual—when calculating DSCR.
DSCR Calculation Example
To illustrate how the calculation works, consider a typical commercial real estate pro forma. Income and expenses are projected annually, resulting in an NOI figure for each year. That NOI is then divided by the property’s annual debt service.
In many cases, a property may not meet a lender’s minimum DSCR requirement in the early years, particularly if it is being acquired with a value-add or turnaround strategy. For example, a property might achieve a DSCR of 1.24X in year one, slightly below the common 1.25X threshold, but improve to 1.30X or higher once operations stabilize.
Lenders may be willing to underwrite to a stabilized DSCR rather than in-place performance, provided there are credible assumptions and mitigating factors supporting the improvement.
Why the Debt Service Coverage Ratio Matters
At its core, the Debt Service Coverage Ratio is a measure of financial resilience. It reflects how much a property’s income could decline—or its expenses increase—before debt payments become stressed.
This is the logic behind the commonly cited 1.25X minimum. At that level, NOI could decline materially and still be sufficient to cover required loan payments. As DSCR tightens toward 1.05X–1.20X, even modest disruptions—such as a tenant vacancy or unexpected repair—can impair debt service.
DSCR Covenants and Ongoing Risk
To formalize DSCR requirements, lenders often include a covenant in the loan agreement. These covenants typically require the borrower to:
- Provide operating statements quarterly or annually
- Maintain a minimum DSCR (often 1.25X) throughout the loan term
If financial reporting shows the DSCR has fallen below the required threshold, the borrower may be required to:
- Make a principal curtailment to restore compliance, or
- Face a technical default under the loan documents
From an investor’s perspective, this represents a real risk. A DSCR covenant can require additional capital contributions beyond the original equity investment, reinforcing the importance of conservative underwriting, proactive asset management, and disciplined expense control.
Global DSCR for Portfolio Borrowers
While DSCR is most commonly evaluated at the individual property level, lenders working with experienced, multi-asset investors may also calculate Global DSCR. This metric aggregates:
- NOI from all properties in the borrower’s portfolio
- Total debt service across all outstanding loans
Global DSCR provides insight into the borrower’s overall financial capacity. A strong DSCR at one property may be offset by weaker performance elsewhere, increasing the lender’s perceived risk. From a credit standpoint, cash flow used to support underperforming assets reduces flexibility and can affect loan approval on new acquisitions.
Final Thought
For investors, understanding DSCR is not just about clearing a lender’s approval hurdle. It is about stress-testing cash flow, evaluating downside risk, and ensuring that leverage enhances—rather than threatens—long-term performance. In practice, treating 1.25X as a floor rather than a target is often a prudent approach, particularly in uncertain market conditions.
