March 31, 2014
As it applies to commercial financing and business loans, debt service coverage ratio, or DSCR, is the percentage of the net profit left over after loan payments are made. DSCR is the percentage of the annual debt service, or ADS, (annual principal and interest) of the net operating income (gross rental income minus expenses). The full name for this calculation is Debt Service Coverage Ratio, or DSCR, but in commercial lending this is usually shortened to DSCR. A loan on an apartment building that has a NOI of $146,000 and ADS of $96,500 has a DSCR of 1.51 – or 1.51 to 1. This is the calculation:
Annual NOI/ADS = DSCR 146,000/96,500 = 1.51
Why is DSCR needed? Because commercial lenders want to know there is a margin of excess income left over after their loan payments are made. Not only does this excess income give the borrower their profit, it also gives the lender a comfort level – knowing that after the payments are made there is some cash left over to cover unforeseen expenses such as an adverse change in occupancy or extra repairs and maintenance. Some business loans, such as SBA (Small Business Administration) loans, have DSCR requirements as low as 1.10. Most apartment loans require a 1.25 DSCR. So for every dollar of loan payment there is an extra 25 cents left over. Commercial properties such as office buildings and shopping centers often require a higher DSCR of 1.30 to 1.35.
Calculating the projected debt coverage ratio can also be useful to the investor purchasing a business or commercial property. Take a look at the past two years of net operating income. Then look at what amount you will want to borrow on the venture. 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. Also ask yourself if the asking purchase price is reasonable. If the projected DSCR is too low, you can then go to the seller with a lower offer, based on the fact that the property at the suggested price will not qualify for financing.
By Terry Painter, President