How to Calculate DSR on a Commercial Loan

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Debt Service Coverage Ratio (DSCR)

The most important ratio to understand when making income property loans is the debt service coverage ratio. It equals Net Operating Income (NOI) divided by Total Debt Service. To understand the ratio it is first necessary to understand the numerator and the denominator. Let’s take a look at net operating income (NOI) first.

 

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Net operating income is the income from a rental property left over after paying all of the operating expenses:

Gross Scheduled Rent

$100,000

Less 5% Vacancy & Collection Loss

$5,000

 

________

Effective Gross Income:

$95,000

 

 

Less Operating Expenses

 

Real Estate Taxes

 

Insurance

 

Repairs & Maintenance

 

Utilities

 

Management

 

Reserves for Replacement

 

Total Operating Expenses:

$30,000

 

Net Operating Income(NOI)

 

$65,000

Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate in an area to cover collection loss. In addition lenders always insist on using a management factor of 3-6% of effective gross income, even if the property is owner-managed. Their logic is that they would have to pay for management if they took back the property. Finally, note that we have not included loan payments as an operating expense.

We Close More Commercial Loans than Anyone!  Call today at 866-400-8630  or 512-650-8630 .

 

Next let’s look at the denominator, Total Debt Service. This includes the principal and interest payments of all loans on the property, not just the first mortgage. Note that we have not included taxes and insurance. They were already accounted for above when we arrived at net operating income (NOI).

To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139

Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14

 

We Close More Commercial Loans than Anyone!  Call today at 866-400-8630  or 512-650-8630 .

 

Obviously the higher the DSCR, the more net operating income is available to service the debt. From a lender’s viewpoint it should be clear that they want as high a DSCR as possible.

The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.

Life insurance companies are very conservative and generally require a 1.25 or 1.35 DSCR. This means that their loan-to-value ratios are low. Savings and loans (S&L’s) generally only require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.

 

We Close More Commercial Loans than Anyone!  Call today at 866-400-8630  or 512-650-8630 .

 

A DSCR of 1.0 is called a break even cash flow. That is because the net operating income (NOI) is just enough to cover the mortgage payments (debt service).

A DSCR of less than 1.0 would be a situation where there would actually be a negative cash flow. A DSCR of say .95 would mean that there is only enough net operating income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to keep the project afloat.

Genearlly lenders frown on a negative cash flow.  Some lenders will allow a negative cash flow if the loan-to-value ratio is less than around 65%, the borrower has strong outside income such as an electronic engineer, and the size of the negative is small. Lenders rarely allow negative cash flows on loans over $250,000.

We Close More Commercial Loans than Anyone!  Call today at 866-400-8630  or 512-650-8630 .

 

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Author: admin

Here’s A Little Bit About Me. 20+ years in the finance industry, I rose to the level of Assistant V.P. with Chase Manhattan. While working for Chase, I decided that I wanted to have residual income without having to quit my job. I bought my first apartment building in 1996, three days before my wedding. In 2001, I decided I would leave the corporate world and work for myself in a net branch environment. My passions are helping people get commercial mortgage loans. I also am passionate about investing, working out and being with my family and friends.