All good commercial real estate investors evaluate properties using a variety of formulas and metrics to determine whether or not it’s a good deal. Lenders do the same in order to determine how much money they’re willing to loan on a deal. The debt service coverage ratio is one of the critical formulas used by lenders and investors to evaluate a property.
What is Debt Service Coverage Ratio?
Debt Service Coverage Ratio (DSCR) measures the borrower’s ability to service or repay the annual debt payment in relation to the Net Operating Income (NOI) the property generates.
In other words, the DSCR measures a property’s ability to pay the loan payments based on its net operating income (NOI). Since the DSCR helps determine whether or not a property can properly service the annual debt payments, lenders use this metric to help establish the maximum amount they’ll loan real estate investors for a new loan or refinancing an existing mortgage.
The DSCR also indicates how much of a safety net the property’s NOI offers in the event market circumstances worsen as well as the level of risk involved in financing an investment property.
How To Calculate Debt Service Coverage Ratio
To calculate the debt service coverage ratio of a property, simply divide the Net Operating Income (NOI) by the Debt Service.
Therefore, the formula for Debt Service Coverage Ratio is:
- Net Operating Income / Debt Service = Debt Service Coverage Ratio
The total of all loan payments (principal and interest only) that the owner will make for a certain property is known as the debt service.
To learn what Net Operating Income is and how to calculate it, read this article: What is Net Operating Income (NOI)?
What is a Good Debt Service Coverage Ratio in Commercial Real Estate?
As with many commercial real estate calculations, “good” is defined on a case-by-case basis by the investor and the investors’ goals.
However, in the case of DSCR, it’s a bit more cut and dry.
If the property’s monthly income is less than the monthly debt commitments, the debt service coverage ratio is less than 1. In this situation, the investor should probably look for other funding sources to pay the loan obligation because it means the Net Operating Income of the property won’t pay for the monthly debt payments on its own.
If the DSCR is 1, it signifies that the investor’s real estate income covers their monthly debt. If the DSCR value is more than 1, the investor’s income is greater than the monthly debt payment and is enough to pay it off.
A decent debt service coverage ratio often falls between 1.25 and 1.5. This means that after paying off your monthly mortgage debt, your rental property generates 25 to 50 percent more money.
Lenders want a property’s net operating income to be high enough to cover loan payments and provide enough buffer to account for a decrease in NOI in the future in the event of rising vacancies or expenses.
What is a DSCR Commercial Real Estate Example?
Let’s say an industrial property generates $200,000 in annual NOI and has $200,000 in annual debt payment. In this instance, the property’s debt service coverage ratio is 1.0x. This is because $200,000 NOI / $200,000 Debt Service = 1 (DSCR).
Based on the information above, when a property’s DSCR is 1 it means the property’s NOI is barely sufficient to meet the loan payment obligations and not a penny more. A lender would be hard pressed to provide a loan with a DSCR ratio of 1 because if the NOI drops for any reason, the property is no longer able to pay the debt (think monthly mortgage payments).
As another example, let’s say a retail property generates $500,000 in NOI and has $275,000 in anndual debt payment. In this instance, the property’s debt service coverage ratio is 1.8x. This is because $500,000 NOI / $275,000 Debt Service = 1.8 (DSCR).
A lender is much more likely to approve retail property loan with a DSCR of 1.8 because it has a respectable amount of “buffer” for the NOI to drop and still be able to repay the debt.
Why Does DSCR Change Over Time?
After an investor buys a property, the debt payment coverage ratio will likely fluctuate.
This is because, assuming the mortgage on the rental property has a set interest rate, the annual debt payment often stays (assuming a fixed interest rate) the same, whereas the NOI can change from year to year.
For instance, let’s say an investor increases rent a few percent every year. The change in DSCR after a holding period of five years might resemble this:
This table makes it easy to see how the DSCR might change over time.
Please note, if the property doesn’t perform as expected or if the investors don’t raise rent over time, it’s also possible for the DSCR to remain flat or even decrease.
The Debt Service Coverage Ratio is an extremely simple formula to utilize as you evaluate a commercial real estate investment. Using the DSCR, you can quickly determine if the NOI of your investment property can comfortably cover the mortgage payments—a critical necessity for any investment property.