Debt service coverage ratio (abbreviated as DSCR) is an important metric for real estate owners who have borrowed or plan to borrow money.
The Liquidity Source is dedicated to providing transparency to its clients. This article will explain why lenders care about DSCR, how to calculate it for commercial real estate, and what the ratio means for your ability to qualify for a loan.
What is Debt Service Coverage Ratio?
The debt service coverage ratio (DSCR), also known as “debt coverage ratio”, is the ratio of operating income available to debt servicing for interest, principal and lease payments. It is a popular metric used in the measurement of an entity’s net income to recognize the maximum number of debt coverage they can afford. DSCR is calculated by dividing net operating income by your annual debt obligations.
Why do lenders care about DSCR?
DSCR is used in order to calculate the borrowers maximum amount of debt that he can recieve from the bank. They want to be certain that you have sufficient regular cash flow over the term of the loan to make your monthly payments. It’s also an important way for you to evaluate the financial health of your real estate investments.
How to calculate debt service coverage ratio
Net Operating Income
Your Net Operating Income is the revenue from your business minus your operating expenses. Operating expenses do not need to include taxes, interest payments, depreciation, and amortization.
Annual Debt Obligation
Your Annual Debt Obligation is the current year’s payments of loan principal, loan interest, loan fees, and, if applicable, lease payments. This includes payments on all obligations that you currently have and the loan you’re applying for.
Interpreting DSCR numbers:
The calculation above will produce your DSCR ratio. Typically banks are looking for a DSCR somewhere between 1.25 and 1.30. Once they use the DSCR calculation, they are able to find the maximum amount for their borrower.
What is a good debt service coverage ratio?
Lenders are looking not only for a DSCR above the banks requirements, the higher the better.
The exact value that lenders are looking for depends on the specific lender and the general economic climate — lenders become more risk averse when the broader economy is not doing as well.
The Liquidity Source is able to assist with each step of the financing process including calculating your own DSCR.
If you plan on applying for a loan, calculating your DSCR will help you determine the loan amount that’s best for your business. Calculating your DSCR in advance shows your prospective underwriter that you understand the fundamentals behind the loan they might provide and how it will impact your business. It’s also an important metric to track in general to understand the health of your real estate business and investments. The Liquidity Source is able to find the best possible outcome with a customized financing solution using its network of lenders, by working directly with commercial real estate owners through the lending process.