September 19, 2020
Why is a DSCR - Debt Service Coverage Ratio needed?
DSCR stands for Debt Service Coverage Ratio and is the most important factor for a commercial lender to analyze the risk level of your business or investment property loan. It is the DSCR that tells the lender that the net income is more than adequate to support the loan payments. You would not want to take out a loan on an income property or business if the net income were just barely able to make the loan payments – or worse if it were less than the loan payments. You would like to have a healthy margin left over for profit right? This is of utmost importance to your lender as well. The margin of cash left over after your loan payments are made is the debt service coverage ratio. Most commercial loan programs require you to have an additional 25 cents left over for every dollar of loan payment. This would be a 1.25 DSCR. The higher this ratio, the lower the lenders risk. A loan on an apartment building that has a annual NOI (net operating income) of $146,000 and annual loan payments of $96,500 has a DSCR of 1.51 – or 1.51 to 1.
How is DSCR Calculated?
The DSCR is basic algebra containing two knows: Annual Net Operating Income and Annual Loan Payments, and one unknown – the DSCR.
NOI – Annual Net Operating Income (Gross Income less all expenses)
Annual Debt Service – Annual Loan Payments (Principal and Interest)
Annual Net Operating Income / Annual Loan Payments = DSCR
Example: Annual Net Operating Income: $136,000 /annual debt Service $96,000 = DSCR 1.42
You can use our easy DSCR Calculator:
What DSCR (Debt Service Coverage Ratio) do Lenders Require?
This ranges from a low of 1.10 for some SBA loans to 1.40 for general commercial properties such as a strip mall that might not have a good history of occupancy or short leases. Often lenders will lower the rate if the loan to value (LTV) is lower and the DSCR is higher than average. Keep in mind that the higher the debt service coverage ratio, the lower the risk to the lender. Once the DSCR is set by the lender’s underwriting guidelines this is not negotiable. If your loan requires a 1.25 DSCR and your net operating income only supports a 1.24 DSCR, there is not going to be a loan at the size you want. You can however take a smaller loan. This is why it is so important for you to determine the DSCR accurately (see next section). Here are typical minimum Debt Service Coverage Ratios for business or commercial properties:
|SBA Loan:||1.10 – 1.25|
|Business Loan:||1.25 – 1.40|
|Apartment Loan 5+Units||1.20 – 1.35|
|Self-Storage||1.25 – 1.35|
|Office||1.25 – 1.40|
|Retail||1.25 – 1.40|
How DSCR Affects the Size of your Loan
It is simple math that the lower the DSCR required by the lender, the more you can borrow. For this example we are using two different lenders, which can lend up to 75% of the purchase price on a $1,000,000, 16-unit apartment building. Both lenders have the same interest rate – 4.75%, and the same amortization – 30 years. The property’s net operating income is $56,338. Lender A requires a 1.25 DSCR and can lend you a maximum of $720,000. Lender B requires a 1.20 DSCR and can lend you a maximum of $750,000. Lender B will win this deal by lending you $30,000 more just because he has a lower DSCR requirement.
How to Determine the DSCR Accurately
It is imperative that you calculate the DSCR the exact same way your lender’s underwriter will. It is also essential that you make sure that the business or investment property income and expenses are absolutely accurate. Sorry, I know this will take some work, but it will be well worth it. The underwriter will not allow any mistakes and will verify all income and expenses. They will determine the DSCR conservatively. So you should do this as well. Here is how the underwriter will calculate income expenses for commercial real estate:
- Prepare an annual pro forma for income and expenses. Start with the month you will own the property if this is a purchase
- Use current rents only as shown on the rent roll
- Allow 5% for vacancy even if the property is 100% occupied. Use actual vacancy if the property has higher vacancy than 5%. The appraiser will also do this
- Allow 5% for management, even if you plan on managing the property yourself. The appraiser will also do this. If you have a quote from a management company use that percentage if it is above 5%
- Get a print out of the insurance requirements from your lender and get a quote for what your actual insurance will cost
- Check with the county and get actual current taxes. If you are in a state that readjusts property taxes based on the sales price be sure to use that amount if you are purchasing the property
- Get copies of actual utility statements or add 3% onto the utility expenses from the prior year. This is what the underwriter will do
- Make sure that you allow enough for repairs and maintenance. If the property has been neglected for many years, your lender will require you to spend more going forward to maintain the property.
- Allow something in the expenses for capital reserves or CapX. If this is a multifamily property the appraiser as well as the lender will add to the expenses between $150 per unit per year—for a new property—to $450 per unit per year for a much older property for capital expenses. These are major repairs or replacements for items such has new roofs, new HVAC, hot water heaters, etc.
DSCR and the Purchase of a Business or Commercial Investment Property
Calculating the projected debt service coverage ratio as part of your due diligence on a purchase of a business or commercial investment property can be very useful. Remember that this ratio is protecting you as well as the lender. Take a look at the past two years of net operating income and annualize the current year. Then look at what amount you will want and are able to borrow on the venture and see if you make the DSCR required by your lender. You can estimate your annual loan payments on this web site by looking up our current mortgage rates for the type of property you are purchasing. We also offer a mortgage calculator. Then, do the DSCR calculation and see if there is enough net operating income to qualify for the loan you want. If you can’t make the DSCR required by your lender, than this might be grounds for renegotiating a better sales price based on the fact that the property at the suggested price will not qualify for financing
DSCR and Commercial Construction Loans
Is a DSCR used by lenders on a commercial construction loan? It would seem that this would not be necessary, since construction loans are based on a percentage of the cost of construction. Furthermore, DSCR is dealing with the net income of the completed, stabilized property and you might think have little to do with a commercial construction loan. However, the answer is YES. The DSCR is of the utmost importance to your construction lender. In fact, it is often the most important calculation of risk for the construction loan. This is because a construction lender always makes sure that the projected net operating income of the property will support a permanent loan. If it does not, then the property might never be able to qualify for a perrmanent loan. Commercial construction loans are temporary loans and usually have a term of twelve to eighteen months. As you can imagine if the property does not qualify for perm financing, then the construction lender could be faced with starting a foreclosure on the completed project. Construction lenders often start with the projected DSCR of the perm loan first – then work backwards to determine if the construction loan is solid.
So how does your construction lender determine the DSCR if the property is not even built yet and has no net operating income? You will need to provide your construction lender with a pro forma rent roll and a one to two year pro forma income and expense statement. The lender will do market research to determine if the proposed rents and expenses make sense. Ultimately, the construction appraisal will determine this. Once the projected net operating income is determined, the lender will estimate the annual loan payments and estimate what the DSCR will be.
DSCR as it Relates to First and Second Mortgages
Many investors wonder if commercial second mortgage lenders do a DSCR calculation to approve a loan. The answer is yes. Your second mortgage lender is taking most of the risk so they will especially want to know that you are above water when making both payments. If you have a second mortgage, both your first and second mortgage lenders will do what's called a cumulative DSCR calculation to make sure that you still have something left over after making both loan payments each month. In most cases, the cumulative DSCR requirement will be a minimum of 1.10 and a maximum of 1.25 when combining both loan payments. When you think about it, a 1.10 cumulative DSCR is a bit scary. It leaves you only 10 cents for your profit after you make your combined loan payemnts. A DSCR this low should only be considered when there is an upside to the net operating income. An example would be if you are taking out the second mortgage to improve the property and then you will be raising the rents to eventually raise the net operating income.
How to Improve the DSCR (Debt Service Coverage Ratio)
For those borrowers who want to maximize the size of their commercial loan (and most do), a DSCR that is too low means that you will have to accept a smaller loan than you ideally want. Even though your loan program might go up to 80% LTV, if your DSCR is too low your loan might be sized at a maximum of 70%. Is there anything you can do to fight for the larger loan size you want? The answer is quite often yes. There are 4 main numerical factors that ultimately determine maximum loan size. These are Net Operating Income, Interest Rate and Amortization, and the required DSCR. By shopping for a more favorable loan program, you might have the opportunity to improve any or all of these and thus increase the size of your loan. Here are some suggestions on how to accomplish this:
- Net Operating Income (Gross Income minus Expenses). You will have to use the historical rent and the rent that is on the rent roll – you can’t change this. But you can possibly lower expenses by finding expenses that are not recurring, or you can lower. Look for one time expenses that will not be recurring such as legal expenses. Look for capital expenses that were written off as repairs. Almost all lenders will allow you to add this expense back to income. Shop for less expensive insurance. Perhaps you can save on management by finding a management company that charges less.
- Interest Rate You can obviously shop for a loan program with lower interest rates, but it is equally important to find out what the underwriting rates is for each loan program. Many loan programs underwrite at a higher rate (lenders call this stressing the rate). This is to insure that if rates go up in the future, you can still refinance the balance.
- Amortization Finding a loan program with a longer amortization (30 years instead of 25) will lower your loan payments and thus raise your DSCR.
- DSCR Finding a loan program that has a lower DSCR requirement will mean a larger loan.
By Terry Painter / President Business Loan Store, Apartment Loan Store