The Debt Service Coverage Ratio (DSCR)
When acquiring commercial real estate, you’ll most likely get financing from lending institutions or a bank.
The commercial real estate loan underwriting process is significantly different from a residential loan.
In most cases the criteria and metrics lending institutions utilize to determine if they’ll lend to you or not is entirely different in commercial real estate.
Among the most crucial metrics used when looking for a commercial real estate loan is the debt service coverage ratio (DSCR).
Below we will take a look at how to compute the debt service coverage ratio and why it’s a vital metric for purchasing commercial real estate!
What is the debt service coverage ratio in commercial real estate?
The DSCR ratio evaluates the borrower’s ability to repay the debt based upon the property’s income and performance.
Lenders use the DSCR to identify the best loan amount, or whether the property can sustain the debt, it is incurring.
How to calculate the DSCR
If you take the property’s annual net operating income (NOI) and divide it by the property’s yearly debt payments, the resulting figure is the DSCR metric, which is typically followed by x.
For example, If you want to purchase a building that generates $500,000 in net operating income and the debt service is $450,000 a year, the DSCR would be 1.11 x.
The DSCR shows that the asset can cover its debt 1.11 times in a given year.
Any DSCR that is less than 1.0 x means that the property doesn’t safeguard the lender’s investment and in almost all cases, the loan will be rejected.
What is an ideal DSCR?
The minimum required DSCR differs from lender to lender and by asset type; however, in general, the majority of lenders try to find a DSCR somewhere in the 1.25 x– 1.5 x range.
This suggests that, at a minimum, the asset can generate an extra 25% of additional income after paying all of its debts.
Also, keep in mind that the debt service coverage ratios alter as the property’s performance fluctuates.
If you acquired a property that had an NOI of $300,000 upon acquisition and your yearly debt service was $250,000, the DSCR would be 1.2 x.
However, if you can decrease expenses and increase rents to market rates, thus growing the NOI to $350,000 by year two, the DSCR would increase to 1.4 x.
If, for whatever reasons, an investment is underperforming, but there’s potential to increase performance through increasing the number of units, raising rents, etc, the loan provider might approve the loan even though the DSCR is listed below the minimum threshold.
Why knowing your property’s DSCR is necessary
Since the DSCR is among the most critical metrics utilized in commercial financing, it’s essential to know the minimum standards required by your chosen lending institution.
You can use this information to assist you in adjusting your offer and guarantee you’re not overleveraging the property in hopes of increasing the possibility of loan approval.
Overall, while the DSCR isn’t the only metric utilized when making an application for a commercial loan, it’s an essential part of getting a loan approved.
By understanding the DSCR metric and how it is associated with the asset’s performance, you can be more informed and prepared when purchasing a commercial real estate property.