How to Calculate the Debt Service Coverage Ratio (DSCR)
Debt Service Coverage Ratio (DSCR)
Debt Service Coverage Ratio (DSCR) is a ratio to measure a property's amount of available cash remaining after servicing the loan payments. In addition to LTV, DSCR is the other loan constraint in any real estate transaction. It is calculated as:
DSCR = Net Operating Income
Annual Loan Payments
Example 1: Suppose an investor owns a property with an NOI of $500,000. The annual principal and interest payment for his loan is $370,000. The DSCR would be:
$500,000 = 1.35x
$370,000
This result means that the property produces a net operating income 35% greater than what is required to pay the loan.
$500,000 - $370,000 = $130,000
$130,000 = 0.35 x 100 = 35%
$370,000
This additional income can be used by the investor as a return on his equity investment or for additional investment into the property. When a loan has an NOI that is equal to the annual loan payment, it is considered to be at breakeven. This means that the property is operating only enough to cover its loan obligations. When a property has an NOI that is below the annual loan payment, it is considered to be operating below breakeven.
Example 2: Assume an investor has a property that has an NOI of $250,000. The annual principal and interest payment for her loan is $275,000. The DSCR would be:
$250,000 = 0.91x
$275,000
This result means that the property only covers 91% of the required debt service payments. It is important to understand why a property may have a low debt service. It may be due to a worse-than-expected performance from market conditions such as declining rent or higher vacancy. Alternatively, the owner may have expensed a roof replacement which artificially lowered the property's NOI and thus making it appear the property is not performing well. Regardless, the investor would be required to pay the bank the amount of money necessary to service the annual debt service or face foreclosure.
When evaluating property, it is important to understand why DSCR constraints vary from lender to lender and from market to market. The higher the DSCR greater equity is needed to purchase a property. And the lower the DSCR less equity is needed to purchase a property. DSCR is one of the restraints in any real estate transaction.
Shortcoming #1: DSCR is not the only loan constraint. Most loans have a minimum debt service coverage ratio (DSCR) and maximum LTV. Simply because a lender tells you they will loan up to a 1.25 DSCR (or whatever their parameter) of a property does not mean you will receive all of the loan proceeds.
Shortcoming #2: DSCR is a calculation of NOI. Care should be taken in understanding how each group determines an NOI. A borrower's pro forma NOI may vary greatly from a lender's NOI and thus both may have different expectations of the necessary equity required in the transaction.
Shortcoming #3: Lenders vary DSCR constraints to make loans less risky. The higher the DSCR the greater the cushion the property has to pay for unexpected expenses or to weather volatile market conditions. Since a higher DSCR requires a greater equity investment, the lender feels their loan is protected.
