The debt-service coverage ratio applies to corporate, government, and personal finance. In the context of personal finance, the debt-service coverage ratio (DSCR) is a measurement of an individual’s available cash flow to pay current debt obligations. The DSCR shows lenders whether a borrower has enough income to pay its debts.
DSCR is a measure of the cash flow available to pay current debt obligations.
DSCR is used to analyze firms, projects, or individual borrowers.
The minimum DSCR that a lender demands depends on macroeconomic conditions. If the economy is growing, lenders may be more forgiving of lower ratios.
The DSCR calculation is rather simple. A business’s DSCR is calculated by taking the property’s annual net operating income (NOI) and dividing it by the property’s annual debt payment. The DSCR is typically shown as a number followed by x.
DSCR= Total Debt Service
Net Operating Income
For example, if you’re looking at purchasing an investment property that produces $500,000 in annual 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 current debt obligations. The higher the DSCR, the more secure the lender’s position, because the NOI is higher in proportion to the debt service.
Since the debt service coverage ratio is one of the most important metrics used in lending, it’s important for the borrower 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 an investment property.
Let’s say a real estate developer is looking to obtain a mortgage loan from a local bank. The lender will want to calculate the DSCR to determine the ability of the developer to borrow and pay off their loan as the rental properties they build generate income.
The developer indicates that net operating income will be $2,150,000 per year, and the lender notes that debt service will be $350,000 per year. The DSCR is calculated as 6.14x, which should mean the borrower can cover their debt service more than six times given their operating income.
DSCR = $2,150,000/$350,000 = 6.14
The minimum DSCR varies from lender to lender and by asset type, but in general, most lenders look for a DSCR in the 1.25 – 1.5x range. This means that, at a minimum, the asset can produce an additional 25% of additional income after all debt payment.
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 cash flow through increasing rents or units, the lending institution may approve the loan even though the DSCR is below the minimum threshold.