Oftentimes, commercial real estate plays require bank financing. Securing financing from a commercial lender is a much different process than obtaining a residential loan, however.
Debt service coverage ratio (DSCR) is a key metric used to determine an applicant’s ability to repay the debt owed on a prospective commercial loan. Below we’ll take a closer look at DSCR and how it can impact your ability to secure commercial financing.
How To Determine Debt Service Coverage Ratio on a Commercial Property
There’s a simple formula for determining an asset’s annual debt service coverage ratio:
Net Operating Income / Total debt servicing=DSCR
Determine an asset’s net operating income by deducting its operating expenses, excluding income taxes. Total debt servicing, meanwhile, includes debt obligations such as lease payments and loan principal plus interest.
Although this is a common approach to determine DSCR, certain lenders may use different calculations to determine DCSR. Additionally, income taxes can skew these numbers slightly since loan interest is tax deductible.
Determining an asset’s DSCR is important because it gives a baseline idea of whether a lender can afford to routinely cover debt obligations. It’s also helpful in establishing maximum loan limits. A debt coverage service ratio of less than 1 signals negative cash flow, so the lender won’t be able to repay debt without incurring capital losses or borrowing more money.
A DSCR of 1 or anything close to that number means the lender could be vulnerable -- any dips in revenue could leave the borrower unable to meet debt obligations. A debt service coverage ratio above 1, however, typically signals the asset will potentially generate enough income to service existing debt.
Here’s an example: An asset takes in 2.5 million after deducting operating expenses. It requires 1 million annually to service existing debt. The DSCR in this case is 2.5, a “good” number for determining a borrower’s ability to meet debt obligations since the borrower in theory could afford to service an asset’s annual debt obligation 2.5 times. An alternative way of looking at this particular DSCR is that the asset generates an additional 1.5 percent of annual income after all debt obligations have been met.
The Bottom Line
Debt service coverage ratio is a common metric used by commercial lenders to help manage risk by determining an asset’s financial strength and therefore a borrower’s ability to meet his or her loan obligations. Generally, a higher DSCR means a more secure position for the lender since the asset is generating cash flow beyond its required debt servicing levels.
Lenders often have different minimum DSCR qualifications, however, so it’s important to know the minimum qualifications required by prospective lenders when applying for a commercial loan. Understanding DSCR can also help investors avoid becoming over-leveraged in a commercial asset, especially with assets that show low debt service coverage ratios.
