December 12, 2017
By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
What is debt service ratio (DSR)? Well, let us start out by saying that although Debt Service Ratio is used more than half of the time by bankers, mortgage brokers and realtors, the correct term is Debt Service Coverage Ratio (DSCR). When you apply for a commercial mortgage, the DSCR is the most important calculation to the lender. DSCR is the margin of net operating income left over to make mortgage payments after all the other expenses are paid. It is a great calculation for showing how profitable your property is to a lender and puts a number on what the risk is to make this loan.
If the debt service coverage ratio is not strong enough, you won’t get the commercial loan you want. This is because the DSCR tells the loan officer if your apartment complex is profitable enough to cover your mortgage, plus unexpected expenses, and still have some profit left over for you. The margin of profit left over after expense and the mortgage payment is looked at as the safety margin for the lender.
Calculating the Debt Service Ratio
To calculate the debt service coverage ratio, the annual net operating income (NOI) is divided by annual loan payments. And to calculate the net operating income, you subtract the expenses of your commercial property from gross income. Your gross income is all the rent you collect for the year, plus income from ancillary fees, such as laundry, late fees, pet fees, etc. .
The principal and interest you pay annually is the annual loan payment. Annual Debt Service is another name for annual loan payment.
Thus, the DSR is the quotient of annual net operating income/annual loan payments. Be sure not to add reserves, taxes, insurance, or anything else in annual loan payments. Again it’s just simply principal and interest, nothing else.
Let’s say $130,000 is the annual operating income of your multifamily property. And $100,000 is annual net payments you are paying: $130,000/$100,000 = 1.3 debt service ratio for your multifamily property. For an apartment building this DCR has an extra margin of safety.
Let’s say you find a property being sold for $1,000,000 and $58,400 is the net operating income for the property. You are applying for $750,000 loan which is 75% of the purchase price. The interest rate is 5.00% and the loan has a 25 year amortization. This makes the loan payment $4,384 monthly or $52,608 annually. Now you take the $58,400 annual net operating income and divide it by the $52,608 annual loan payments. This scenario shows a 1.11 Debt Coverage Ratio. When the lender sees this they immediately turn down the loan because there is no margin of safety at all. Keep in mind that they require a 1.25 DCR. After all, you only have 11 cents left over for profit for every dollar of loan payment. This represents too much of a risk for the lender and for you too.
What is the DSR Required by Most Lenders?
Did you know that different types of commercial properties have different debt service ratios? That is because different types of commercial properties have differing levels of risk. Hotels are much riskier than apartment properties for example. So, the DSR for a hotel is going to be 1.40 or more most likely. An apartment building requires a DSR of 1.25 most of the time. Office and Retail properties require a 1.35 to 1.40 DSR. Self-Storage usually requires a 1.35 DCR. Most business loans require a 1.40 DSR, with the exception of SBA loans which can go down as low as 1.10.
How DSR Protects You
The following situations are where you may need a safely cushion: Do you have enough of a cushion to cover vacancies that just come up, big emergency repairs, capital expenses, etc.? How about if some of your military tenants are deployed? Or what if the neighborhood your property is in starts declining, and vacancies start to appear in your property.
The realty recession of 2008 occurred largely because lenders did not ask for enough margin for their debt service ratio. This created a national crisis of many banks going out of business from massive numbers of foreclosures. If only the lenders held to the “True North” of banking survival. Be profitable, but not greedy. Another way of saying it is if you take a lot, you need to give a lot. A secret to life is to actually give more than you take. Then you create a “Bank Account” filled with people who give you a lot.
A standard for multifamily lenders is that for every buck you pay toward your mortgage, 25 cents or more is available for a cushion to pay other expenses. Thus, you have a 1.25 DSR, and for the loan officer, an acceptable amount of risk. The higher the debt service ratio, the more lenders love the loan. And if your DSR is higher than they ask for, you may get a lower loan rate.
Also, the majority of lenders want the net income from property rent alone to handle the loan mortgage payments. You can’t have your income from other sources, investments, etc. help pay the mortgage. Again, it comes back to the margin of safety. An old saying was “Location, Location, Location,” pertaining to real estate. “Margin of Safety, Margin of Safety, Margin of Safety,” would be a good slogan for mortgage lenders. It protects them and it protects you.
How about if your debt service ratio on your property is 1.50 – a very high DSR? It’s high because it means you have a safety net of 50 cents for each dollar you make toward your mortgage. Lenders will love you.
How about if you’ve got a debt service ratio of 1.05. This is an incredibly low DSR – you have 5 cents margin of safety. Unless you are a super strong company like Apple Computer, you hardly have a chance to get a DSR of 1.05, because there is barely any margin of safety to protect you or the bank.
Calculating the Debt Service Ratio
Another important thing that commercial lenders examine is how stable a company is. And of course, a company’s stability is so strongly connected to the DSR of a company. Getting back to apple computer, it is a super strong company. And this will give them a much more favorable loan. They might get as low as a 1.05 DSR. It cannot be stressed enough here how important it is for individuals—as well as businesses—to work towards establishing a strong fiscal foundation and strong reputation. As a rule, in the financial world, the stronger you are fiscally, the less you pay. And the weaker you are financially in the fiscal world, the more you pay.
Some banks give their very wealthy customers practically unheard low rates and terms. And these banks will battle hard to keep these customers – beating out all competition, giving rates and terms no other competition will give.
When Applying for a Loan
Because level of risk is so important to banks, there are a couple of things you can do to have a better chance of landing the loan: 1. Have a higher debt service coverage ratio than required. An example would be that your bank requires a 1.25 DSR, but you have a 1.4 DSR. You have substantially lowered the level of risk. This is a great situation to ask your lender for a lower rate.
2. You can accept a lower loan to value than required. Let’s say your multifamily property merits an 80 % loan to value. But you will accept a 70% loan to value. This lowers the loan risk. You might get a lower loan rate if you ask for it.
Remember to always ask for what you want. Do not wait for someone to offer it to you. Some things are negotiable. I remember someone telling me that if you don’t ask, you’ve got an automatic no.
However it’s most important to realize that the DSR is not open for negotiation once it is set by his guidelines of underwriting.
Let’s say your loan officer gives you a 1.25 DSR, but your net operating income accepts only a 1.21 DSR, the loan size you will get will be less. But you can accept a lesser size loan than you want so you could be owner of the property. It is so helpful for you to know how to calculate the debt service ratio because it is so pivotal in knowing the loan size the lender can give you. And knowing the size of the loan you can get when you are looking at a property is very valuable.
It really comes down to a simple statement. The lower the debt service ratio your loan requires, the more you can borrow. The Debt Service Ratio is one of the most important calculations for you to become familiar with. If you are in the market for acquiring a property it could quite possibly save you a lot of time and money. Knowing the DCR of the property can tell you the risk level a mortgage officer will perceive before you apply for the loan. Be sure to ask the commercial loan officer what the minimum DCR is for their loan program before you apply to make sure it will be a fit. It will give you peace of mind to know that the subject property is worth investing in at the price.