What You Need to Know About Debt Service Coverage RatiosPaul Winterowd
Debt Service Coverage Ratio (DSCR) is an important constraint to understand when determining the leverage of your commercial multifamily loan. In fact, it is likely the first thing that your lender will look at when determining your loan amount.
What is the DSCR?
Debt Service Coverage Ratio represents the amount of cash flow you have left over after expenses divided by your debt payments on the property. This is calculated on an annual basis. Simply put, the DSCR is the ratio between the income of your property (Net Operating Income) and the debt service (Principle and Interest) of your loan. The DSCR will let the lender know the amount of money, or cash flow, you will have after you make your debt payment.
How is it calculated?
DSCR is calculated by taking your annual Net Operating Income (gross income less all expenses) and dividing it by your annual debt service, or your annual loan payments (principal and interest).
A high DSCR will improve the leverage you can achieve on your loan. Most commercial lenders will want to see a minimum DSCR of 1.25, and in some cases a higher ratio.
Suppose you want to buy an apartment building and need a loan of $700,000. The first thing you are going to want to do is calculate your DSCR. Let’s assume the annual NOI totals $160,000, and your required debt service is $125,000. To calculate your DSCR, you take your NOI (160,000) and divide it by your debt service (125,000). This will give you 1.28 – your debt service coverage ratio. The calculation is shown below:
If a lender is asking for a DSCR above 1.25, you are in a good position. The higher this ratio, the lower the lender’s risk, which is something that will make your loan more attractive to them.
The DSCR is a great way for lenders to analyze the risk level of approving a loan for your commercial or multifamily property. Make sure you have a clear understanding of the DSCR, and how it is calculated. This knowledge will help you better strategize what you need to do to get the correct financing on your next multifamily or commercial project.
Note: Lenders prefer high DSCR’s because it reduces their risk in that there is plenty of income to cover the debt payments. All commercial multifamily loans have minimum DSCR’s that lenders require of their borrowers. For example, if the maximum LTV on a loan is 80%, but your calculated DSCR is less than what is required to get 80% LTV, your loan amount will be reduced until the lender’s minimum required DSCR is obtained. It is not uncommon for a property with a low cap rate to require more equity, like a 65-75% LTV, in order to maintain a lender’s required minimum DSCR for the loan. This is simply because decreasing cap rates produce higher values with the same cash flow.