Understanding The Debt Service Coverage Ratio—The Backbone Of Commercial Real Estate
Commercial real estate is one of the biggest industries across our country and is much more complex than you may realize. In each real estate transaction, there are a lot of components and moving parts that help move a sale and purchase along and everything that comes along with them. This can include negotiations, appraisals, contracts, renovations, etc. Many people are familiar with the general terms and processes; however, many of them are unaware of what is debt service coverage ratio (DSCR) is, as well as how important of a role it plays in a commercial real estate transaction.
What is DSCR?
Debt service coverage ratio, simply put, is the ratio of the net operating income of a business or a property to its debts, expenses and obligations. This helps lenders, financers and investors measure a property or company’s ability to pay their debt or mortgage from the cash flow generated from the property. DSCR is the same as debt to income (DTI) in residential real-estate. However, the difference is that in residential, percentage to service the debt is dependent on your personal income, whereas in commercial, it is based on the property’s income.
How do we determine what the DSCR is?
For example, let’s say that the debt to service ratio for a mortgage is $100,000 annually and the lender wants a debt service coverage of 1.2. The lender will want to see that the property is generating $120,000 after paying their expenses like taxes, gas, heating, insurance, etc. This ensures that the property is generating enough cash to pay its expenses and its mortgage with a cash buffer. The lender wants to see that after you take the income from the property less the expenses (gas, electric and so on) that the balance leftover can service the mortgage.
A debt service coverage ratio above 1 shows that the company is generating a profit and is sufficient enough to pay out its obligations and debts completely from the cash flow. The higher the ratio, the more debts a company can take on and is capable to pay, making it more attractive to lenders. From the example above, a DSCR of 1.2 would indicate that the property is making 120% of what is needed to service the debt. If the DSCR ratio is below 1, this reflects that the business is unable to pay back its current debts from the net operating income.
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How is DSCR applied to commercial real estate?
In commercial real estate, many businesses may look to finance new properties to either start or expand business. The first thing many lenders look at when deciding to finance a property is the DSCR to determine if they are willing to lend and if so, how much they are willing to lend. The DSCR is super important as it helps lenders evaluate how much they can lend and get repaid without the business defaulting as well as how much of a mortgage a property can carry. A DSCR can indicate a lot about the management of a business and its efficiencies as well as its inefficiencies.
Many lenders will look for a specific DSCR minimum to lend on, generally at least a 1.25. As the DSCR gets higher over time, the borrower can then look to refinance since there is a higher income to service a higher debt.
Final Thoughts
All in all, the DSCR is a very important factor when it comes to commercial real estate. Any lender considering financing a property will want a buffer to ensure their debt is paid and that the business can pay it back. Unlike residential real estate where personal credit is the most important, the DSCR is likely the first number lenders will look at and arguably the most important as it is the determinator of how much financing a lender is willing to lend.