We have addressed Debt Service Coverage Ratio (DSCR) in the past on the Visio blog, but I want to revisit the topic since it is such a critical component of underwriting for Small Balance Commercial (SBC) lenders.
DSCR is the measure of a cash flowing property’s ability to cover its debt obligations (loan payment) after expenses. It is calculated by dividing the Net Operating Income (NOI), which is the gross income minus vacancy minus operating expenses, by the annual debt service.
DSCR=NOI/Annual Debt Service
For example, a property generates an NOI of $75,000 annually and its annual Debt Service is $61,799, so the equation would like this:
DSCR=$75,000/$61,799
DSCR=1.21
This is commonly expressed as 1.21x, meaning the cash flow generated from the property is sufficient to cover the annual debt service 1.21 times over (i.e. NOI > Debt Service). A DSCR of less than 1.00x means the property cash flow is insufficient to cover its annual debt service (i.e. NOI < Debt Service).
Most lenders have a minimum DSCR which is usually 1.20x or even higher. While DSCR determines the ability of a cash flowing asset to cover its debt, it should be noted, that the DSCR can be altered by a changing in the interest rate or changing the amortization period.
Look at the following three scenarios: (i.) base case, (ii.) a five (5) year reduction in the loan amortization, and (iii.) an interest only loan payment:
|
Base Case |
|
Change in Amortization |
|
Interest Only |
|
|
Loan Amount |
$ 950,000 |
$ 950,000 |
$ 950,000 |
||
|
Interest Rate |
5.00% |
5.00% |
5.00% |
||
|
Amortization (Years) |
30 |
25 |
N/A |
||
|
|
|||||
|
Debt Service |
$61,799 |
$67,405 |
47500 |
||
|
|
|||||
|
Net Operating Income |
$ 75,000 |
$ 75,000 |
$ 75,000 |
||
|
|
|||||
|
DSCR |
1.21x |
1.11x |
1.58x |
||
As we can see from the table above, the Base Case provides a DSCR of 1.21x, which would satisfy most Small Balance Commercial lenders minimum DSCR. Just a five (5) year reduction in the amortization period results in a loan that would fail most Small Balance Commercial lenders DSCR requirements. Finally, if we look at an interest only loan with the same basic loan parameters, the DSCR soars to almost 1.60x with no change in the interest rate.
The examples above, show how the DSCR can be easily adjusted by changing only one loan parameter. As a broker, you need to be working with an experienced Small Balance Commercial lender to help determine the right loan program for your borrower. Check in regularly to read more about SBC lending, and check out the "Small Balance Commercial" section of our blog.
For more investor tools and resources, visit our blog.
