The Debt Service Coverage Ratio, often abbreviated as “DSCR”, is an important concept in real estate finance and commercial lending. It’s critical when underwriting commercial real estate and business loans as well as tenant financials, and it is a key part in determining the maximum loan amount. In this article we’ll take a deep dive into the debt service coverage ratio and walk through several examples along the way.
What Is Debt Service Coverage Ratio (DSCR)?
The debt service coverage ratio (DSCR) measures the ability of a borrower to repay its debt. The DSCR is widely used in commercial loan underwriting and is a key formula lenders use to determine the size of a loan.
Debt Service Coverage Ratio (DSCR) Formula
The debt service coverage ratio formula depends on whether a loan is for real estate or a business. While the logic behind the DSCR formula is the same for both, there is a difference in how it is calculated.
DSCR Formula for Real Estate
For commercial real estate, the debt service coverage ratio (DSCR) definition is net operating income divided by total debt service:
For example, suppose Net Operating Income (NOI) is $120,000 per year and total debt service is $100,000 per year. In this case the debt service coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals 1.20. It’s also common to see an “x” after the ratio. In this example it could be shown as “1.20x”, which indicates that NOI covers debt service 1.2 times.
DSCR Formula for a Business
For a business, the debt service coverage ratio definition is EBITDA divided by total debt service:
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. For example, if EBITDA for a company was 240,000 for the last fiscal year, and total debt service was 141,000, then the DSCR would be 1.7x.
Sometimes there will be variation in how the debt service coverage ratio is calculated. For example, capital expenditures are commonly excluded from the DSCR calculation because capex is not considered an ongoing operational expense but rather a one time investment. Lenders will have credit policies that define how the debt service ratio is calculated, but there is often still some variation depending on the situation. It’s important to clarify how the DSCR is calculated with all parties involved.
Debt Service Coverage Ratio (DSCR) Meaning
What does the debt service coverage ratio mean? A DSCR greater than or equal to 1.0 means there is sufficient cash flow to cover debt service. A DSCR below 1.0 indicates there is not enough cash flow to cover debt service. However, just because a DSCR of 1.0 is sufficient to cover debt service does not mean it’s all that’s required.
Typically a lender will require a debt service coverage ratio higher than 1.0x in order to provide a cushion in case something goes wrong. For example, if a 1.20x debt service coverage ratio was required, then this would create enough of a cushion so that NOI could decline by 16.7% and it would still be able to fully cover all debt service obligations.
What is a Good Debt Service Coverage Ratio?
What is the minimum or appropriate debt service coverage ratio? Unfortunately there is no one size fits all answer and the required DSCR will vary by bank, loan type, and by property type.
However, typical DSCR requirements usually range from 1.20x-1.40x. In general, stronger, stabilized properties will fall on the lower end of this range, while riskier properties with shorter term leases or less creditworthy tenants will fall on the higher end of this range.
How to Calculate DSCR for Real Estate
The DSCR is critical when sizing a commercial real estate loan. Let’s take a look at how the debt service coverage ratio is calculated for a commercial property. Suppose we have the following Proforma:
As you can see, our first year’s NOI is $778,200 and total debt service is $633,558. This results in a year 1 debt service coverage ratio of 1.23x ($778,200/$633,558). And this is what the debt service coverage ratio calculation looks like for all years in the holding period:
As shown above the DSCR is 1.23x in year 1 and then steadily improves over the holding period to 1.28x in year 5. This is a simple calculation, and it quickly provides insight into how loan payments compare to cash flow for a property. However, sometimes this calculation can get more complex, especially when a lender makes adjustments to NOI, which is a common practice.
Adjustments to NOI When Calculating DSCR
The above example was fairly straightforward. But what happens if there are significant lender adjustments to Net Operating Income? For example, what if the lender decides to include reserves for replacement in the NOI calculation as well as a provision for a management fee? Since the lender is concerned with the ability of cash flow to cover debt service, these are two common adjustments banks will make to NOI.
Reserves are essentially savings for future capital expenditures. These capital expenditures are major repairs or replacements required to maintain the property over the long-term and will impact the ability of a borrower to service debt. Similarly, in the event of foreclosure, a professional management team will need to be paid out of the project’s NOI in order to continue operating the property. While an owner managed property might provide some savings to the owner, the lender will likely not consider these savings in the DSCR calculation.
Other expenses a lender will typically deduct from the NOI calculation include tenant improvement and leasing commissions, which are required to attract tenants and achieve full or market based occupancy.
Consider the following proforma, which is the original proforma we started with above, except with an adjusted NOI to account for all relevant expenses that could impact the property’s ability to service debt:
As you can see in the proforma above, we included reserves for replacement in the NOI calculation as well as a management fee. This reduced our year 1 NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR? Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This is much lower than what we calculated above and could reduce the maximum supportable loan amount or potentially kill the loan altogether. Here’s what the new DSCR looks like for all years in the holding period:
Now when the debt service coverage ratio is calculated it shows a much different picture. As you can see, it’s important to take all of the property’s required expenses into account when calculating the DSCR, and this is also how banks will likely underwrite a commercial real estate loan.
For questions regarding your real estate investments call Jon Whitcomb at Metro East Commercial Real Estate at 651.283.4884.