Knowledge Center
How to Calculate the Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio is one of the least understood underwriting requirements for new and even seasoned commercial real estate investors. Briefly, the debt service coverage ratio simply compares the subject property’s net operating income to the proposed mortgage debt service (on an annual basis). The lender wants to ensure there is sufficient cash flow to cover the new mortgage debt, and then some. Learn more about the debt service coverage ratio (DSCR).
It’s important to understand the concept and math behind the DSCR if you are calculating your own cash flow analysis for a prospective commercial loan or apartment loan, whether it’s a purchase or refinance. If the property is operating more efficiently than comparable properties (due to self-management, not keeping up with R&M, etc.), or not including a minimum vacancy percentage, both the underwriter and appraiser will use a vacancy factor and bring expenses in line with market – which reduces the NOI thereby lowering the DSCR and loan amount.
Below is a basic example of how a commercial lender calculates the DSCR for a commercial mortgage. The lender holdbacks are highlighted in blue, remember these are not actual expenses, but are deducted from the property’s gross income for underwriting purposes. The example below assumes a 75 unit property multifamily property. Be sure to use gross potential rents (GPR) and not actual collected rents for rental income. Why? Because an underwriter and appraiser will use GPR and apply a vacancy percentage. If you aren’t using GPR and using a vacancy percentage you will essentially be double counting vacancy (assuming you had a vacancy during the year). Additionally, if rents have increased you will want to be sure to use the most current rents in your analysis and not the previously lower rents.
| Income | |
| Gross Potential Rents | $1,000,000 |
| Other Income | |
| Total Annual Gross Income | $1,000,000 |
| Less 5% Vacancy & Collection Loss | $50,000 |
| Effective Gross Income: | $950,000 |
| Expenses | |
| Real Estate Taxes | $15,000 |
| Property Insurance | $5,000 |
| Repairs and Maintenance | $5,000 |
| Pest Control | $5,000 |
| Janitorial | $5,000 |
| Utilities | $5,000 |
| 5% Off Site Management Reserve | $50,000 |
| Replacement Reserves Estimated at | $15,000 |
| $200 Per Unit @ 75 Units | |
| Total Operating Expenses: | $105,000 |
| Net Operating Income (NOI) | $845,000 |
Now that we have calculated the NOI, we must calculate the annual debt service for the property. The annual debt service is the simply the total amount of principal and interest payments made over a 12 month period. Taxes and insurance are not included in this calculation as they are accounted for in the expenses of the property.
To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the annual debt.
| Commercial Loan Size: | $10,000,000 |
| Interest Rate: | 6.5% |
| Term: | 30 Years |
| Annual Payments (Debt Service) = | $758,475 |
| Net Operating Income (NOI) = | $845,000 |
Now we can calculate the DSCR:
DSCR = Net Operating Income / Annual Debt Service
| NOI = | $845,000 |
| Total Debt Service = | $758,475 |
| Annual Payments (Debt Service) = | $758,475 |
| DSCR = 1.10 ($845,000 / $758,475) |
What this example tells us is that the cash flow generated by the property will cover the new commercial loan payment by 1.10x. This is generally lower than most commercial mortgage lenders require. Most lenders will require a minimum DSCR of 1.20x.
If a DSCR is 1.0x, this is called breakeven, and a DSCR below 1.0x would signal a net operating loss based on the proposed debt structure.
