How Does Debt Coverage Ratio Affect Commercial Real Estate Loans?
Debt Coverage Ratio (DCR), is a measurement of a property’s net operating income divided by its debt service. A property’s Debt Coverage Ratio, which is also known as its Debt Service Coverage Ratio (DSCR), is one of the most important eligibility factors for commercial real estate loans. Keep in mind that net operating income can be calculated by subtracting a property’s gross revenue by its operating expenses. DCR/DSCR can also be applied to an entire company, as well as a single property, which is more relevant in the case of owner-occupied commercial properties.
Lenders place a huge emphasis on DCR, and rightly so, as it’s one of the best indicators that a borrower will be able to make their commercial mortgage payments on time and avoid a loan default. If the borrower has the money to pay, the thinking goes, than it typically won’t be a major issue for them to pay their loan back. While DCR is essential for commercial real estate loans, it’s also important for small business loans, like the SBA 7(a) loan, whether or not the loan will be used for commercial real estate, working capital, equipment, or other business expenses.
Debt Coverage Ratio in Practice
In the example below, we’ll take a look at how the DCR formula could apply to an income-generating commercial property, such as an apartment building or a self-storage facility.
If a building has a net operating income of $300,000/year, and a combined annual debt service of $225,000, we would apply the formula net operating income/debt service to determine the property’s DCR.
$300,000/$225,000 = 1.33x DCR
Calculating Net Operating Income for the Debt Coverage Formula
While the formula above is an easy way of calculating a property or business’s DCR/DSCR, if your net operating income (NOI) isn’t calculated correctly, it could lead you to an inaccurate result, and overestimating (or underestimating) the amount of commercial real estate financing you may be eligible for. In most cases, lenders utilize EBITDA (earnings before interest, taxes, depreciation, and amortization) in order to calculate a property’s NOI.
What is the Acceptable Debt Coverage Ratio for Commercial Real Estate Financing?
If a property has a debt coverage ratio of less than 1, it is actually losing money, which means that it will be ineligible for most kinds of commercial real estate financing, except for perhaps hard money loans or other types of high-interest, emergency loans. In general, most lenders prefer a DCR/DSCR of at least 1.20x. However, certain types of loans will go below this. For instance, HUD multifamily loans, such as the HUD 221(d)(4) loan for multifamily construction and substantial rehabilitation, and the HUD 223(f) loan for multifamily acquisitions and refinancing, permit DCRs as low as 1.15x for affordable housing properties and as low as 1.11x for subsidized properties.
Despite the fact that certain loans have lower DCR eligibility limits, the higher your DCR, the easier it will be to get a commercial real estate loan on good terms— including longer, fixed-rate terms, lower interest rates, non-recourse provisions, lower fees, and smaller prepayment penalties with shorter durations.
In addition, it’s important to realize that lenders often require riskier types of properties to have significantly higher DCR. For instance, most lenders prefer hotel and self-storage properties to have a DCR of at least 1.40x, due to the fact that these property types have incredibly high turnover and revenues that can fluctuate greatly by season (and even by the day).
Certain Lenders May Utilize Global DCR/DSCR
If you’re an individual or small business commercial real estate borrower, rather than a larger company or institution, a lender may utilize a somewhat different form of DCR/DSCR in order to gauge your eligibility for financing. This type of debt coverage ratio is called global DSCR, and it takes into account personal debt and personal income. This can be highly beneficial if you have a lot of personal income and little debt, but it can be disastrous if you have little additional income and large personal debts, such as home mortgages, credit cards, and hefty student loan debts.