If you plan on investing in commercial real estate, you'll likely get financing from a bank or lender. The loan underwriting process differs greatly from a residential loan, including the metrics lenders use to determine if they'll loan to you or not.
One of the most important metrics used when applying for a commercial loan is the debt service coverage ratio (DSCR). Let's take a look at how to calculate debt service coverage ratio and why it's an important part of investing in commercial real estate.
What is debt service coverage ratio in commercial real estate?
The debt service coverage ratio examines the borrower's ability to repay the debt based on the property's income and performance. Lenders use the DSCR to determine the maximum loan amount or whether the property can sustain the debt it is incurring.
Calculating the debt service coverage ratio
The debt service coverage ratio is calculated by taking the property's annual net operating income (NOI) and dividing it by the property's annual debt payments. The DSCR is typically shown as a number followed by x.
For example, if you're looking at purchasing an apartment complex that produces $500,000 in net operating income and the debt service is $410,000 a year, the DSCR would be 1.22x. If a property has a DSCR of 1.22x, it means the asset can cover its debt 1.22 times in a given year.
If the DSCR is less than 1.0x, it indicates that the property doesn't have enough income to support its annual debt service. The higher the DSCR, the more secure the lender's position, because the NOI is higher in proportion to the debt service.
What is the ideal DSCR?
The minimum DSCR varies from lender to lender and by asset type, but in general, most lenders look for a DSCR in the 1.25x–1.5x range. This means that, at a minimum, the asset can produce an additional 25% of additional income after paying all debts.
Debt service coverage ratios change as the property's performance changes. For example, if you bought a property that had an NOI of $150,000 upon acquisition and your annual debt service was $130,000, the DSCR would be 1.15x. However, if you can lower costs and increase rents to market rates, thereby growing the NOI to $180,000 by year two, the DSCR would increase to 1.38x.
If the investment is underperforming but there's the potential to increase performance through increasing rents or units, the lending institution may approve the loan even though the DSCR is below the minimum threshold.
Why knowing your property's DSCR is important
Since the debt service coverage ratio is one of the most important metrics used in commercial lending, it's important to know the minimum qualifications required by a lending institution. This can help you adjust your offer to produce the appropriate DSCR and ensure you're not overleveraging the property in your effort to increase the likelihood of getting a loan approved.
While the debt service coverage ratio isn't the only metric used when applying for a commercial loan, it's a crucial part of getting a loan approved. By understanding how the metric works and how it relates to the asset's performance, you can be more informed and prepared when buying a commercial property.