Understanding the DSCR or Debt Service Coverage Ratio in Commercial Mortgage Lending
When underwriting a commercial real estate loan, one of the most important factors used to determine the approvability of a commercial mortgage request is the DSCR, commonly referred to as the debt service coverage ratio.
The DSCR is a ratio used to analyze the amount of debt that can be supported by the cash flow generated from the property. Or, simply the net income generated by the property divided by the new commercial mortgage payment.
In commercial mortgage lending, the DSCR is equivalent to the debt-to-income, or DI ratio in residential lending. Whereas in residential lending, the income and expenses used in the calculation are the borrower's, it is the exact opposite in commercial mortgage lending. The income and expenses used in calculating the DSCR ratio are derived from the commercial property.
Understanding the DSCR and Commercial Mortgage Lending
One of the most frequent reasons a commercial loan is denied is because the property does not meet the commercial lender's minimum DSCR requirements. Understanding how a commercial mortgage lender calculates the DSCR can be helpful to know when applying for a commercial real estate loan, conduit loan, or apartment loan.
DSCR = NOI/Total Debt Service
A common misconception made by borrowers when applying for a commercial mortgage loan is that the bank or commercial lender only uses the expenses from the property when calculating the NOI. Commercial mortgage lenders use the actual expenses plus additional holdbacks, such as, off-site management, vacancy, replacement reserves, repairs and maintenance, etc. Commercial lenders add these numbers to the expenses for several reasons, including, should the borrower default - management fee holdback, should the property lose a tenant (s) -vacancy factor, increase in costs, buffer for unexpected repairs, etc.
Calculating the Debt Service Coverage Ratio - DSCR -
Here is a basic example of how a commercial mortgage lender calculates the DSCR for a commercial loan request. The lender holdbacks are highlighted in blue, remember these are not actual expenses, but they are deducted from the property's gross income for underwriting purposes. Example assumes a 75 unit property multifamily property.
Gross Rents $1,000,000
Total Annual Gross Income $1,000,000
Less 5% Vacancy & Collection Loss $50,000
Effective Gross Income: $950,000
Real Estate Taxes $15,000
Property Insurance $5,000
Repairs & Maintenance $5,000
Pest Control $5,000
5% Off Site Management Reserve $50,000
$200 Per Unit @ 75 Units $15,000
Total Operating Expenses: $105,000
Net Operating Income (NOI) $845,000
Now that we have calculated the NOI, we must calculate the total debt service for the property, or simply determine the loan payment consisting of only the principal and interest. We do not include the taxes and insurance 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 commercial mortgage loan payment.
Commercial Loan Size: $10,000,000 First Mortgage
Interest Rate: 6.5%
Term: 30 Years
Annual Payments (Debt Service) = $758,475
Now we can calculate the DSCR:
DSCR = Net Operating Income (NOI) = $845,000
Total Debt Service $758,475
DSCR = 1.10
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.
Recently a new breed of commercial lenders, including CommercialBanc, are offering commercial real estate loans based on a global DSCR. A global DSCR is a ratio that combined both personal and property income and expenses when calculating the DSCR. This allows for a propertys with weak cash flow, or a property in a low CAP area, to still qualify for a commercial loan provided the borrower has additional income to add the the property's NOI.