Many investors new to commercial real estate have trouble getting a handle on the various metrics used in the industry. In fact, there are some experienced professionals who don’t actually have a clear sense of how to define these metrics. The DSCR or debt service coverage ratio is one of the most fundamentally important concepts in the commercial mortgage space. When it comes to financing your property, every commercial lender will utilize this metric. It therefore behooves you as an investor to really understand what DSCR is all about. If you don’t feel completely comfortable with this topic, this blog post is for you.
In short, debt service coverage ratio is the basic relationship between a property’s net operating income (NOI) and its annual mortgage payments (which include both principal and interest payments). Think about this example. A commercial property in New York City generates $125,000 in net operating income. The owner of this property pays $100,015 in annual principal and interest payments. The DSCR of this property is a shade under 1.25 (1.249). Let’s dig a little deeper into this example to really flesh out the concept. Assume the following profit and loss statement illustrates the annual income and expense of the above property:
Gross Potential Rents: $200,000
Less 5% Vacancy & Collection Loss: $10,000 Effective Gross Income: $190,000
Real Estate Taxes $20,000
Property Insurance $10,000
Repairs & Maintenance $8,000
Pest Control $4,000
5% Off Site Management Reserve $10,000
Total Operating Expenses: $65,000
Net Operating Income (NOI): $125,000
After calculating the total gross income and deducting the operating expenses, we see that the property generates $125,000 in net operating income. Now let us consider the mortgage payment on the property:
Mortgage Terms and Balance
Commercial Loan Size: $1,750,000
Interest Rate: 3.98%
Term: 30 Years
Annual Debt Service: $100,015
With these numbers in mind we are ready to calculate the debt service coverage ratio. Remember that this property generates $125,000 and the borrower must pay $100,015 annually. In order to arrive at the DSCR, you simply divide the NOI ($125,000) by the debt service ($100,015). As mentioned above, this equation is equal to about 1.249. You might be thinking to yourself “why does this metric matter?” Well, it’s actually quite simple. If you break down this concept, what we’re really saying here is that the building generates about $1.25 in income for every $1 you owe to the lender for your mortgage payment. If, for example, the DSCR of a property would be at 1, that would indicate that the property generates just enough money to cover the mortgage payments and if the DSCR is under 1, that means that the building income can’t cover the proposed loan terms.
Since commercial mortgage loans are primarily based on the cashflow of the particular asset, lenders want to make sure that the property generates enough income to cover the mortgage payments. This is in contrast to residential mortgages where the debt to income metric is used. In the commercial space, lenders typically want to make sure the property income itself covers the mortgage (independent of other outside income the borrower may have). In case any unforeseen incidents happen during the term of the loan such as vacancies or extra expenses, lenders want to make sure that the property actually generates more annual income than the annual mortgage payments. It’s fairly standard in the industry to look for a DSCR of at least 1.25 when underwriting a commercial loan. If a proposed loan amount does not reach the lender’s benchmark debt service coverage ratio, the loan is said to be debt service constrained and the lender will be forced to reduce the loan amount.
While most lenders strictly consider the property income when calculating DSCR, there are some lenders that make commercial real estate loans based on what’s known as “global DSCR”. These lenders will combine both personal and property income and expenses when calculating the debt service coverage ratio. Thus, if a property has a weak cash flow but the borrower has other supplemental income which brings his overall income above the lender’s DSCR threshold, the loan will still be doable. For example, if the property in the case above only generated $100,015 (at a 1 DSCR) but the borrower has supplemental income of $25,000, the global DSCR would meet the 1.25 DSCR requirement.
One last thing to remember when calculating debt service coverage ratio is how lenders calculate expenses. Often, many borrowers only include the actually generated expenses of the property in their calculations. While this may sound intuitive, lenders don’t typically operate that way. Even if a property is fully occupied, lenders will typically assume a vacancy factor of about 5% to safeguard against any future vacancies that may pop up. Furthermore, lenders will typically assume a management fee of about 5% of the effective gross income (even if the property is self-managed). The reason this is done is because lenders have to underwrite based on the potential that they will need to foreclose on the property and hire an outside management company to manage the property. They need to make sure that the property will still generate enough income in such a situation. Lastly, lenders will often assume an annual repair and maintenance fee of about $750-$1,000 per unit (even if the actual repair expense is much less). It’s really important to remember to calculate DSCR based on how the lender will look at it. After all, they are on the ones lending the money!
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