Nearly all commercial real estate transactions are financed with some combination of debt and equity. The equity comes from the potential property owner and/or their investors while the debt comes from a bank or non-bank lender. The exact amount of each can vary by transaction, but equity typically consists of 15% – 25% of the purchase price while debt consists of the remaining 75% – 85%.
One of the major benefits of commercial real estate investment is that debt is widely available for most property types at generally favorable terms (including loans with both amortizing payments and interest payments). But, those terms can vary significantly by lender and property type so it is important for potential owners/investors to understand what they are, how they are calculated, and why they matter. One of the most important terms, a financial ratio known as the Debt Service Coverage Ratio (DSCR) is widely used, but commonly misunderstood.
The Debt Service Coverage Ratio is a measure of a property’s Net Operating Income (cash flow) to its annual loan payments / debt obligations and it is used by lenders to assess the risk in a given transaction.
How is the Debt Service Coverage Ratio Calculated?
The formula used to calculate the Debt Service Coverage Ratio is relatively simple:
But, calculating annual Net Operating Income (NOI) can be a bit tricky. Broadly, Net Operating Income is calculated as a property’s income (e.g. Rent), minus all reasonably necessary operating expenses (e.g. taxes, insurance, maintenance). However, deciding exactly which expense line items to include can be a choice that varies from one lender to another. Some use a metric called EBITDA, Earnings Before Interest, Taxes, Depreciation, and Amortization, while others use their own standard. This is what can make it tricky.
Annual debt service, sometimes referred to as total debt service and used to calculate the mortgage constant, is defined as the contractually obligated annual debt payments based on the loan amount, interest rate, term, and amortization outlined in the bank Loan Agreement.
To illustrate how the calculation works, an example is helpful. The following table shows a typical proforma for a commercial real estate asset:
From the table above, it can be seen that income and expenses are calculated for each year. However, there is one expense line item, Depreciation, that can occasionally be a source of confusion in the DSCR calculation. Depreciation is a non-cash expense, meaning that it is an accounting expense only and it does not represent actual money leaving the property owner’s bank account. Some lenders include it in the Total Expense figure and some don’t. The ramifications of this decision can be the difference between a loan approval and a loan decline.
While the specific debt service coverage requirements can vary by property type and lender, a general rule of thumb is that a minimum of 1.25X should be achieved. So, in the table above, the property does not reach this level until year 3 if depreciation is excluded or year 4 if depreciation is included. This would not necessarily cause the lender to automatically decline the request, but it may force them to look at “mitigating factors” to make up for the deficit.
Why the Debt Service Coverage Ratio Matters
Fundamentally, the Debt Service Coverage Ratio is a measure of risk. Put another way, the Debt Service Coverage Ratio is a measure of a property’s ability to absorb changes in income and/or expenses while maintaining its ability to make its required loan payments. This is the logic behind the minimum DSCR requirement of 1.25X. Net Operating Income could fall by a material percentage and still produce enough cash flow to make the required loan payments.
To codify this requirement, a commercial lender may insert a “covenant” into the loan agreement that outlines the consequences of failing to maintain 1.25X debt service coverage at all times during the loan term. For example, the language in the covenant may state that the borrower is required to provide operating statements for the property on a quarterly or annual basis. If these statements show that there is not enough income to maintain a 1.25X debt service coverage, the borrower could be required to make a principal payment in an amount sufficient to increase the DSCR back to 1.25X or higher.
To that end, this type of covenant represents a risk to the investor that they may need to contribute more capital to a deal beyond their initial investment. This puts additional pressure on them to ensure that leases are renewed on time and that expenses are minimized to ensure they remain in compliance with DSCR covenants at all times.
Interested in Learning More?
First National Realty Partners is one of the nation’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. As part of our pre-purchase due diligence, we calculate the Debt Service Coverage Ratio for all of our deals and work closely with our lenders to negotiate covenants and remain in compliance with them at all times.
Whether you’re just getting started or searching for ways to diversify your portfolio, we’re here to help. If you’d like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.