The DSCR is simple to calculate yet provides lenders with powerful insights to your business. By comparing cash flows to debt obligations, the ratio helps lenders assess your ability to cover the loan payments. In essence, it helps determine if you can pay back the loan on time and in full.
The formula to calculate the DSCR is as follows:
DSCR = Annual Net Operating Income / Annual Debt Payments
Annual NOI = Gross Income – Total Operating Expenses
Annual Debt Payments = Principal + Interest
When calculating the DSCR for a property the NOI must first be calculated. From your net income subtract all operating expenses and vacancies.
Do not include the principal and interest or capital expenditures in operating expenses. However, insurance and taxes should be included.
The annual debt payments, or debt service, should reflect all principal and interest payments made in a year.
How Lenders Use the Debt Service Coverage Ratio
Lenders use the ratio to assess the borrower’s ability to repay the loan in full and on time. If the DSCR is less than 1 this indicates the property is not generating enough revenue to cover the loan payments. A ratio higher than 1 indicates the property is generating enough revenue to meet debt obligations.
Lenders like to see a DSCR greater than 1. A ratio of 1.2 is a common minimum requirement.
If your ratio is too low then the only solution is to cut your debt service payments. This translates into a lower loan amount. You can quickly understand why a low ratio would be an issue for a borrower looking to acquire a property.
Debt Service Coverage Ratio Example
Let’s assume you have a property generation $100,000 in revenue, with total operating expenses of $48,000, and an annual debt service of $40,000. What is your DSCR?
First, calculate the NOI as follows:
NOI = Revenue – Operating Expenses = $100,000 – $48,000 = $52,000
Next, calculate the DSCR:
DSCR = NOI / Debt Payments = $52,000 / $40,000 =1.3
The ratio is greater than 1.2 so in this scenario the lender would look favorably upon issuing the loan.
What would happen if interest rates were on the rise, causing the total debt payments to increase to $45,000?
DSCR = NOI / Debt Payments = $52,000 / $45,000 =1.16
The higher annual debt payment lowers the ratio to 1.16, less than the 1.2 many lenders require. Notice that changes don’t have to be large to pose a big issue.
Pro Tip: Use Excel, or a similar spreadsheet application, to make manipulating the variables much easier when conducting a case analysis. You can find a simple Excel debt service coverage template here.
Reducing the Loan Balance
If the DSCR falls below 1.2 the options are limited. One solution is to reduce the amount borrowed. The bank can lower the balance until the DSCR meets their requirements.
This is a simple process achieved by reversing the formula in the prior example. Let’s give it a shot.
DSCR = NOI / Debt Payments
1.2 = $52,000 / Debt Payments
With a mandatory 1.2 DSCR the maximum debt payments are $43,333. The lender can now determine the final loan balance based on the interest rates and loan terms they provide.
As for the borrower, he or she will need to scramble to come up with the remaining balance of the down payment. Once again, the importance of a strong DSCR is clearly shown.
The DSCR and Your Cash on Cash Returns
Using the inputs to the DSCR it is possible to determine your cash on cash returns.
Using the above example let’s assume the property in question costs $1,000,000. The down payment is $250,000.
The annual revenue is the same at $100,000 and the NOI is $52,000.
Under the original scenario with annual debt payments totaling $40,000 you are left with $12,000 in cash flow ($52,000 – $40,000).
The cash on cash return can be calculated as follows:
Cash on cash return = Total cash flow / Total cash invested
Cash on cash return = $12,000 / $250,000 = 4.8%
The 4.8% tells us that for every $100 invested in the property, you will receive $4.80 each year. This shouldn’t be confused with the overall return on investment.
Final Thoughts on the DSCR
The final thought on the DSCR is that it should not be your final thought. If you are experienced in the world of commercial real estate or if this is your first time around the block, this ratio is one that can make or break your transaction.
Understanding this ratio and how it can work for or against you may be the difference between finding success and being met with disaster.