Debt Service Coverage Ratio 'DSCR'

Debt service coverage ratio "DSCR" is an underwriting term used by lenders that effectively sets a minimum for the amount of net operating income available to cover the debt service. The ratio is often set right around 1.25, sometimes it's 1.2 sometimes 1.3, depends on the industry, the market, the market timing and the product type debt service coverage ratio tells us how much extra cushion we need to have in our net operating income over the debt service or the annual loan payments. In this case, a 1.25 debt service coverage ratio means that the NOI needs to be 125% or 1.25 times the amount of the annual loan payments. 

Debt service coverage ratio sets a limit on how much risk the lender is going to take in terms of what they loan compared to the cash flow on the property. They don't want to put borrowers in a position where they have barely enough net income to cover the debt service or even worse, not enough net income.

So the debt service coverage ratio builds in the amount of cushion that they want. Lenders can adjust this for competitive reasons or market reasons, but it typically is about 0.25 over the debt service amount. So let's take a look at an example. 

Imagine a property has 100,000. Dollars of net operating income.

But if we look at our formula, if 1.25 is our minimum ratio, that means that 1.25 equals 100,000 divided by X would make X 80,000. So this makes 80,000 our maximum annual debt service. So we take that number. We divide it by 12 and we know that our maximum monthly loan payment is going to be $6,667. So understanding this, if the debt service coverage ratio dictates what our maximum loan payment can be, then one thing that we need to recognize is that our debt service that is allowed by the lender is capped at $6,667. 

If interest rates go up, the payment cannot go up beyond that. So if interest rates rise, then the loan amount would have to go down for an order for us to stay within the minimum required debt service coverage ratio. Let's look at the numbers behind that.

So if we've already determined that our. Debt service coverage ratio is a minimum of 1.25, and we have $100,000 in net income.

Then we know that X, which in this case would be 80,000 is our maximum debt service per year or. 66 67 per month. Let me show you how this would be calculated in the face of changing interest rates or perhaps a shorter amortization period. 

So let's imagine we're punching this into our financial calculator. In this example, I'm going to use a 30 year fixed loan with monthly payments at 6% fully amortizing.

So here's what we've determined. We've determined that our maximum loan payment. Each month can only be $6667. 

If we have a 6% interest rate and we're doing a 30 year or 360 month amortization, we get a $1,112,000 maximum potential loan. 

If interest rates in this case should go up to 7%, still amortized over 30 years. And knowing that our payment can't go up, this would bring our maximum loan amount to $1 million. Similarly, if we still had a 7% interest rate, But our amortization was shortened to say 25 years or 300 months. And our payments still capped at $6667, then our loan amount would be reduced even further to 943,000. 

So debt service coverage ratio, again, tells us what the percentage of the net operating income. Over the debt annual debt service needs to be. And as we can see, annual debt service can be affected by both interest rates and amortization.

Most importantly, what we need to remember here is debt service coverage ratio lets us know how much extra net operating income we have over our loan payments.

Trevor Calton is the founder of Real Estate Finance Academy. Since 1997, he has analyzed, acquired, or sold more than $5 billion of commercial real estate assets, financed over 500 commercial investment properties, and overseen the asset management of over 6000 units of multifamily housing.

He has been teaching commercial real estate classes and training professionals since 2005. His commercial real estate classes and real estate finance development program helps people at all levels develop a successful real estate investment strategy.