What Is Debt Service Coverage Ratio (DSCR)?

How Debt Service Coverage Ratio Works

Simply put, DSCR is a way to evaluate if a business or an investment can pay off its debt obligations. Using the net operating income and all of its annual debt obligations such as principal, interest, lease payments etc., the DSCR, determines if a business has enough money to honor its debt payments with the current level of operations.

Example of Debt-Service Coverage Ratio

Consider a company XYZ Ltd with a debt-service coverage ratio of 4. This means that XYZ limited can cover its debt payments (principal, interest, lease payments etc.) four times over with the current level of operating income.

Why Is Debt Service Coverage Ratio Important?

The DSCR plays a crucial role lending decisions especially for commercial property loans and loans to small businesses. A business with a higher DSCR may be considered a more prudent borrower whereas a company with a lower DSCR may be considered a higher risk of default.

For businesses themselves, the DSCR can provide good insight into the company's financial health. Business owners can check-in on the DSCR periodically to see how the company is doing on that front. Any continued trends of declining DSCR can prompt a rethink of business strategies, gearing them more towards reduction of debt or improvement of operating income.

Debt Service Coverage Ratio in Commercial Loans

Commercial lenders are quite careful in their underwriting. Commercial property is purchased to generate income, so one of the criteria that's popular is to look at the income to see if it is enough to adequately pay the mortgage and leave a profit for the borrowers. When a lender looks at an apartment or multifamily property, whether a mortgage will be granted, and for how much, could be determined using the DSCR. The lender isn't really concerned much with individual credit scores or histories of the owners. The investment's purpose is return on investment, and more importantly cash flow.

For investors into commercial property the DSCR can serve as a gut-check on the investment decision. They will want to see financials that show income and expenses. They will then determine if these numbers look like they'll continue into the future, or possibly get better or worse. When the numbers show that the cash flow will adequately cover the debt service, it validates the investment selection and valuation skills of the investor(s).

Both investors and lenders have a common goal in this respect. Is the project going to be profitable enough to service the debt with adequate profit left over?

Debt Service Coverage Ratio For Small Business Loans

Getting capital or lines of credit is very important for small businesses and having a good DSCR can only help. In some cases, though, having a strong DSCR may not be optional but an eligibility requirement set by the lender.

How To Calculate Debt-Service Coverage Ratio

The formula to calculate debt-service coverage ratio is pretty simple:

Debt-Service Coverage Ratio (DSCR) = Annual Net Operating Income / Annual Debt Obligations

Let's look at an example of a DSCR calculation for an investor seeking a loan to purchase a commercial property. We'll calculate and interpret DSCR numbers both from the lender and the investor's point of view.

Calculating DSCR From A Lender's Perspective

The lender would need some information before calculating the DSCR for a commercial property. Let us assume the following numbers:

Gross income (which in this case would be the rent): $187,000/year
Vacancy & credit loss: 9%
Expenses: 72,470

Step 1: Calculate the cash flow, or gross operating income after subtracting vacancy and credit losses.

Rent totals of $187,000/year - 9% vacancy & credit loss ($16,830) = $170,170

Step 2: Determine net operating income (NOI), by subtracting all other expenses for operation and management, including taxes and insurance.

Net Operating Income = Gross Operating Income - All Expenses = $170,170 - 72,470= $97,700

Monthly Net Operating Income = $97,700 / 12 months = $8,142/month

Step 3: If the lender is using a minimum acceptable DSCR of 1.20, then that $8,142/month would have to be 1.2 times the monthly mortgage payment. To get to that maximum payment, it is necessary to divide the $8,142 by 1.2.

$8,142 monthly net income / 1.20 minimum DSCR = $6785/month maximum mortgage payment.

Step 4: Now it is only necessary to determine how much would be loaned at current rates. If this buyer can expect an interest rate of 6.875% on a 30 year loan, a mortgage calculator will tell us that the lender may be willing to loan around $1,032,836 on this property, as that loan and interest rate would result in principal and interest payments of $6785/month, at the minimum 1.20 DSCR. Most mortgage calculators will let you enter the payment, interest rate, and time to calculate loan amount.

Understanding Debt-Service Coverage Ratio From An Investor's Perspective

The investors do their own calculations and look to their chosen lender to validate the numbers they came up with.

So, let's just do a DSCR calculation where we know the current project's expenses and mortgage payment. If you're looking to invest in a project that may yield an annual net operating income of $223,000 but require you to pay $172,000 in annual mortgage, your DSCR would be:

$223,000 Net operating income / $172,000 Annual Mortgage Payments = 1.30 DSCR

1.3 is better than 1.2 in this case, so probably an acceptable DSCR. However, if a new loan is being sought on an operating project, current NOI would be used as we did at first to see what might be available as a mortgage amount.

When the numbers work, investors and lenders can feel good about the project funding and future profitability.

Frequently Asked Questions (FAQs)