What is DSCR: the debt service coverage ratio?
A property's debt service coverage ratio or DSCR, is a comparison between its net operating income (NOI) and debt service on an annual basis. By looking at a property's DSCR, a lender can determine whether a project is making enough income to pay its debts. In general, DSCR is one of the most important considerations when a commercial mortgage broker, lender or bank is underwriting a loan. DSCR may change with manipulation of the loan terms, such as amortization, in order to increase or reduce annual debt service. The following formula will help you easily calculate a property's DSCR:
For example, an 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 (his income is 1.11x his annual debt service). A DSCR of 1 means a property is making just enough income to pay its debts, while a property with a DSCR of less than 1 means the property isn't making enough to pay its debts. Therefore, commercial lenders always want a project to have a DSCR somewhat higher than 1 to reduce the likelihood of a default or foreclosure.
DSCR Requirements for Commercial Mortgages
The general starting point on commercial mortgages is a 1.25xDSCR (though 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 will subtract gross income from anticipated operating expenses. Debt service would include a calculation of interest and principal payments given the life of the loan and fixed interest rate.
Typically, DSCR requirements are higher on riskier property types, such as hotels, since their income can vary based on competition, seasonal factors, and other economic trends. Many lenders prefer hotels to have a DSCR of 1.40 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 1.05. Other average property type DSCR requirements include:
- 1.40 for self-storage
- 1.25 for industrial
- 1.25 for multifamily
- 1.25 for offices
- 1.50 for assisted living
DSCR, LTV, and the Commercial Loan Approval Process
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, say, 75%, but will not have DSCR within a lender's acceptable range. In this case, the loan is considered "debt-service constrained," and the loan amount and LTV will have to 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), to see if they have other sources of income that can bolster the project's net operating income in the case of any financial distress. If a property owner does have other income sources, it will increase the borrower's global DSCR and can allow them to get a larger loan.
How Commercial lenders Calculate Net operating income (NOI)
In order to accurately estimate their DSCR, borrowers first need to know the net operating income (NOI) of their property. However, when lenders calculate NOI, they look beyond the project's typical expenses; they also look at:
- Market expenses
- Replacement reserves
- Potential vacancy
- Any off-site management expenses (even if the borrower's property is owner-managed, and does not have any)
- Tenant improvement and leasing commissions (TI/LC) (for office and retail transactions)
For example, lender-calculated NOI can be significantly reduced when a building has a much lower vacancy than buildings in the area, but their 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 will often be 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, DSCR is used by lenders to assess risk in approving a new loan. Some lenders prefer more stable measures of risk, such as the debt yield, which measures net operating income by the outstanding loan amount. To recap, debt yield is calculated by dividing a project's NOI by it's loan amount and multiplying it by 100 to achieve a percentage. For example, a property with an NOI of $1 million and a loan amount of $10 million would have an debt yield of 10%. In real estate, debt yield gives a more definitive timeline of recouping the loan funds in the event of foreclosure.