So, what is a debt service coverage ratio?
A debt service coverage ratio, also known as a debt coverage ratio or DSCR, is the ratio of cash available for what's known as servicing debt (generally principal and interest mortgage payments). This benchmark is commonly used in measuring an entity's – usually a person or a corporation – ability to produce enough funds to completely cover their debt payments, including payments delegated to leases. The higher the ratio gets, more easier it becomes for that entity to obtain financing.
Why is a debt service coverage ratio important?
The debt service coverage ratio is important for several reasons. It's important to understand DSCR in the case of calculating cash flow analysis for a prospective loan for commercial real estate and, in some cases, residential real estate. People who are interested in purchasing an apartment building tend to get their DSCR calculated in order to understand more about their prospective purchase.
The ratio itself compares the target property's net operating income to the target mortgage debt service on an annual basis. The lender, the party who gets the calculation, does so to ensure that there will be enough cash flow to successfully cover the new mortgage debt taken on by the borrower.
How do lenders and entities calculate a debt service coverage ratio?
In order to calculate a debt service coverage ratio, those handling the calculation divide the net operating income (referred to as NOI) by the entity's annual debt service. To provide an example, the formula for calculating debt service coverage ratio looks like this:
DSCR = Net Operating Income / Annual Debt Service
DSCR = 1.10 ($845,000 / $758,475)
DSCR = 1.10x
The formula shows that the cash flow generated by the target property will end up covering the new commercial loan payments by 1.10x. This figure is actually considered lower than what many commercial mortgage lenders do require. Most lenders require a minimum DSCR of 1.20x.
Debt service coverage ratios of at least 1.0x are considered to be in the breakeven range, while any figures below 1.0x would be a net operating loss for the prospective debt structure taken on by the entity.
Why is the debt service coverage ratio important to commercial real estate underwriting?
The debt service coverage ratio is important because it provides valuable information to lenders concerning a borrower's ability to sustain and pay off debts for a commercial or multifamily property. In other words, it's important know because it helps lenders learn if their borrowers can successfully generate enough cash flow to cover their loan payments.