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How Debt Service Coverage Ratio Is Used in Multifamily Finance
The debt service coverage ratio (DSCR) is calculated by dividing the net operating income (NOI) by the entity's annual debt service.
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’s — ability to produce enough funds to completely cover their debt payments, including payments delegated to leases. The higher the ratio gets, the easier it becomes for that entity to obtain financing.
Why Is the 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.
For lenders, the DSCR is important in underwriting commercial real estate loans because it provides valuable information concerning a borrower's ability to sustain and pay off debts for a commercial or multifamily property. In other words, it's important to know because it helps lenders learn if their borrowers can successfully generate enough cash flow to cover their loan payments.
The ratio itself compares the target property's net operating income to the target mortgage debt service on an annual basis.
How Do You 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 the debt service coverage ratio looks like this:
DSCR = Net Operating Income ÷ Annual Debt Service
DSCR = $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 considered lower than many commercial mortgage lenders 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. At the same time, any figures below 1.0x would be a net operating loss for the prospective debt structure taken on by the entity.
What Is a DSCR Loan?
There are loans available across the commercial real estate spectrum based solely on a property's debt service coverage ratio. Known as DSCR loans, they can be used for multifamily properties as well as office buildings, retail assets, and more. This type of loan generally maxes out at $5 million and bears higher interest rates than many other types of financing, but they do offer some key advantages.
The main advantage of a DSCR loan is its speed of execution. DSCR loans typically only look at the borrower's property, not the borrower. That means it can be a fast, effective option for investors with less-than-perfect credit, so long as the asset is generating a high enough net operating income to more than cover its annual debt service.
How to calculate DSCR?
- 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.Learn more →
What is the typical range for DSCR loan interest rates?
- Interest rates for a DSCR loan typically range from 3.5% to 6% above the current market rate for loans. This range may vary depending on the specific circumstances of the loan and the financial market.Learn more →
What are the differences between Debt Yield and DSCR?
- The main difference between the two metrics is that DSCR focuses on the property's ability to cover its annual debt payments, while debt yield focuses on the property's ability to generate income relative to the loan amount. In general, a higher DSCR or debt yield is favorable for the borrower, as it indicates that the property has a strong income-generating potential.Learn more →
What is the debt service coverage ratio (DSCR)?
The debt service coverage ratio (DSCR) is a measurement of an entity’s cash flow vs. its debt obligations. It is calculated by dividing the net operating income of a business by the total debt service amount:
DSCR = Net Operating Income / Total Debt Service
If an entity has a DSCR less than 1, its income is less than its monthly debt obligations. In contrast, if an entity has a DSCR of 1, then its income is equal to its monthly debt obligations, while if it has a DSCR of more than 1, its income is greater than its monthly debts.
How does the DSCR affect commercial real estate loan underwriting?
The Debt Service Coverage Ratio (DSCR) is an important factor in commercial real estate loan underwriting. It is a measure of a property’s cash flows relative to its debt service obligations. A lender will use a DSCR calculation to determine if a property generates enough net income to cover its debt obligations. Generally, the higher the DSCR, the more likely a lender is to offer a competitive loan. Most lenders require a DSCR of at least 1.25x. Source and Source.
What are the benefits of a higher DSCR for a commercial real estate loan?
The main benefit of a higher DSCR for a commercial real estate loan is that it will result in better loan terms for the borrower. As mentioned in this article, if a multifamily property has a DSCR above 1.5x, the borrower will receive far better terms than if the asset has a 1.2x DSCR. Additionally, DSCR loans generally allow for unlimited cash out, which could be useful in the event of an unexpected or large property expense.
What are the risks of a lower DSCR for a commercial real estate loan?
A lower DSCR can be a sign of higher risk for a commercial real estate loan. A DSCR below 1.25x indicates that the property's net income is not enough to cover its debt obligations. This means that the borrower may not be able to make their loan payments, and the lender may not be able to recoup their investment. Additionally, a lower DSCR may indicate that the property is over-leveraged, meaning that the borrower has taken on too much debt relative to the value of the property. This can lead to a higher risk of default and foreclosure.
What are the most common DSCR requirements for commercial real estate loans?
The most common DSCR requirements for commercial real estate loans are a DSCR of 1.25x or higher. This means that the property must generate enough net income to cover its debt obligations. You can use a DSCR calculator to determine if a property meets this requirement. Additionally, lenders may also assess the property’s value and other factors such as credit and financials.
How can investors improve their DSCR to qualify for a commercial real estate loan?
Investors can improve their DSCR to qualify for a commercial real estate loan by:
- Increasing revenues: This can be done by expanding the customer base, increasing prices, or introducing new products or services.
- Reducing expenses: A company can look for ways to cut costs, such as negotiating lower prices for supplies, reducing overhead, or streamlining operations.
- Paying down debt: Paying off existing debt will reduce the amount of debt the company has to service and improve the DSCR.
- Refinancing debt: If the company is unable to pay off its existing debt, it may be able to refinance it at a lower interest rate, which will reduce the amount of money needed to service the debt and improve the DSCR.
- Increasing the time period over which debt is repaid: Extending the repayment period will reduce the amount of money needed to service the debt each month, improving the DSCR.
- Increasing equity: A company can improve its DSCR by increasing the amount of equity it has relative to debt. This can be done by retaining earnings, issuing new stock, or selling assets.
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