When analyzing leveraged commercial real estate (properties you acquire using debt) assets, one of the most important metrics to look at is something known as the Debt-Service Coverage Ratio. The Debt-Service Coverage Ratio (DSCR) is a ratio that compares your net operating income to your debt obligations. Typically the higher the ratio, the lower the risk, resulting in more cash flow and a more attractive deal to your lender since you should have more than enough income to cover your expenses. In order to calculate your DSCR, you need to know your current net operating income (all revenues less recurring operating expenses for the property. This is before debt service and any one-time charges.) and what your total debt service (annual debt service payments and other financial obligations like a sinking fund) will be.
Here’s an example of the DSCR formula:
Let’s say we are buying a stabilized 200 Unit multifamily apartment building for $10mm.
We have $700,000 in Net Operating Income.
We are putting down 25% equity, or $2.5mm. So we are borrowing $7.5mm.
Let’s say the terms on that money are a 25-year amortization at a 5% interest rate. Our annual payment will be about $526,000. Of that, the loan payments will be roughly 300k towards the principal and 226k towards the interest payments. Note that we operate with triple net leases in place, where the tenant is covering the insurance, taxes and maintenance in their lease payments. If your property is structured differently, make sure you’re considering all of your debt in your total debt service.
Take your $700,000 in NOI and divide it by your total debt service of $526,000 and your DSCR is: 1.33
So for every $1.33 we take in, we are paying out a $1 in debt. For some investors this is perfectly acceptable, for others this would never work. The higher the number, the less “risky” the deal and vice versa.
Why is the DSCR Important in Commercial Real Estate?
DSCR is one of the major metrics a commercial lender will look at when analyzing your deal. Higher DSCR’s equal less risk to the lender servicing a commercial real estate loan. When a lender is comfortable with a company’s ability to service the bank loan on a commercial property, you’re going to qualify for your loan that much faster. In the deals we underwrite, we generally have loan amounts in excess of 10 million. It’s been our experience that the banks typically like to have a minimum DSCR of 1.3% at that loan amount. We generally look for a similar DSCR, based on the deal, because we know we’ll have enough cash flow to cover the loan payments as well as operating expenses.
In corporate finance, some people working in commercial lending may use a global DSCR to understand the borrower’s ability to repay future and current debt obligations. The global DSCR considers not only the deal in question, but all free cash flow and debt payments from the borrower, any guarantors, and the business. We won’t spend a lot of time here but wanted to make you aware of it. The formula you would use to calculate this is:
Global DSCR = (net operating income + personal income) / (business debt service + personal debt service)
Our take on DSCR
If you are a business owner working in real estate, especially a small business that may not have the personal income or annual net operating income that a larger institution typically has, calculating your DSCR can help you to qualify your deal before you take it to a lender to analyze. In any sort of real estate investing, The DSCR calculation above is a simple one that is worth putting into your underwriting practice. Just a side note, I hate high leveraged deals. Anyone who has ever owned real estate knows that sometimes “anything that can go wrong, will go wrong.” That’s why you need to model your numbers conservatively. I prefer buying an asset after a highly leveraged guy messes up.