DSCR: Debt Service Coverage Ratio In Commercial Property Loans

What is DSCR: Debt Service Coverage Ratio? 

Debt service coverage ratio, or DSCR, compares a property’s annual net operating income (NOI) to its annual debt payments. By looking at a property's DSCR, a lender can determine whether a project is taking in enough operating income to cover its debts. DSCR is one of the most important considerations when a commercial mortgage broker, lender, or bank underwrites a loan.

Debt Service Coverage Ratio Formula and Example

DSCR can easily be calculated by using the formula below:

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For instance, a commercial property with a net operating income of $1,000,000 and a debt service of $900,000 would have a DSCR of $1,000,000 / $900,000, or 1.11 (the income is 1.11x the annual debt service).

A debt service coverage ratio of 1 means a property is generating enough income to make its loan payments, while DSCR of less than 1 means it is not. Therefore, commercial lenders always want a project to have a DSCR higher than 1 to reduce the likelihood of a default or foreclosure. It’s important to realize that DSCR may change with manipulation of the loan terms, such as amortization, in order to increase or reduce annual debt service.

What are the DSCR Requirements for a Commercial Mortgage?

The general starting point for commercial mortgages is a 1.25x DSCR. However, this number fluctuates depending on who the lender is, the property type, the submarket, amortization, and other factors. The "x," which is sometimes included in DSCR, means that the project's NOI covers the project's debts 1.2 times. To calculate the net operating income, lenders subtract gross income from anticipated operating expenses. To calculate the debt service, lenders simply add up the annual principal and interest payments.

Typically, DSCR requirements are higher on riskier property types, such as hotels, since their income varies based on competition, seasonal factors, and other economic trends. Many lenders prefer hotels to have a DSCR of 1.40x before approving a loan. In comparison, DSCR requirements are often relaxed for properties in which national tenants have signed a long-term, triple net lease. These leases are called credit tenant leases (CTLs), and may allow a borrower to get approved with a DSCR as low as 1.05x. In addition, certain types of multifamily financing, such as HUD multifamily loans and some types of Freddie Mac and Fannie Mae multifamily loans, may also allow DSCRs as low as 1.05x for properties with an affordability component.

In general, average property type DSCR requirements include: 

DSCR vs. LTV for Commercial Loans

In addition to DSCR, loan-to-value (LTV) ratio is one of the most important factors in the commercial mortgage approval process. In many cases, a loan will have an acceptable LTV (i.e. 75%) but will not have DSCR within a lender's acceptable range. In this case, the loan is considered "debt-service constrained." As a result, the loan amount must be reduced until the loan gets within the lender's approved range.

In some cases, lenders will look beyond the specific DSCR of the property, and instead, will look at something called global DSCR. Global DSCR looks at the property owner's personal income and expenses (or the income and expenses from their related business entities). This way, a lender can see a borrower has other sources of income that can bolster the project's net operating income in the case of financial distress. If a property owner does have other income sources, it increases the borrower's global DSCR and can allow them to get a larger loan. Global DSCR is often more important for small business commercial property loans, such as the SBA 504 or SBA 7(a) loan.

How Commercial Lenders Calculate Net Operating Income (NOI) for DSCR

In order to accurately estimate DSCR, borrowers first need to know the net operating income (NOI) of a property. However, when lenders calculate NOI, they also consider a project's:

For example, lender-calculated NOI can be significantly reduced when a building has a much lower vacancy than buildings in the area, but the NOI is still discounted based on average vacancy rates. Therefore, when a lender calculates a project's NOI for the purpose of a loan, it is often far less than the project's NOI in practice, resulting in a lower DSCR and a smaller loan amount.

DSCR vs. Debt Yield as a Measure of Loan Risk  

Often, lenders use DSCR to assess risk in approving a new loan. However, some lenders prefer more stable measures of risk, such as the debt yield. Debt yield is calculated by dividing a project's NOI by its loan amount and multiplying it by 100 to achieve a percentage. When compared to DSCR, debt yield gives lenders more definitive timeline of recouping their funds in the event of a foreclosure.

DSCR vs. Debt Yield Example

For example, a property with an NOI of $1 million and a loan amount of $10 million would have a debt yield of 10%. This does not change regardless of the amount of the loan or the monthly payments. In contrast, DSCR can easily vary.

For instance, in the example above, if the loan was issued at a 6% interest rate with a 15 year amortization, the annual debt service would be approximately $1,012,000, giving us with a DSCR of 1.01x, which would not be accepted by most lenders. However, if we extended the amortization to 30 years, the annual debt service would be only $720,000, providing us with a DSCR of 1.38x, well within the acceptable range for most commercial lenders.

Right now, debt yield is mainly used by CMBS lenders, which experienced some of the most severe issues during the mortgage crisis of 2008. Debt yield is not yet commonly utilized by banks, life companies, and agency lenders, as they typically lend to less risky borrowers.


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