Two Key Commercial Ratios

Most of Commercial Real Estate Lending can be boiled down to the results of two ratios:

1. Debt Service Coverage Ratio (DSCR) or Debt Coverage Ratio (DCR)
2. Loan-To-Value (LTV) Ratio

The bulk of the energy spent “processing” a loan is merely an attempt to verify the numbers that go into the numerator and denominator of the above ratios. Today I will cover Debt Service Coverage ratios, and I will post an update later on the Loan to Value ratio.


Debt Service Coverage Ratio

The most important ratio to understand when making income property loans is the Debt Service Coverage Ratio. The DSCR is a sophisticated ratio used on almost all income producing properties. It is defined as:

Debt Service Coverage Ratio = Net Operating Income
_______________________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.

Net operating income is the income from an income producing property after paying all of the operating expenses. A simplified example may look like this:

Gross scheduled Rents______________$100,000
Less 5% vacancy & collection loss_______$ 5.000
Equals Effective Gross Income_________$ 95,000

Less Operating Expenses
_________Real Estate Taxes
_________Insurance
_________Repairs & Maintenance
_________Utilities
_________Management
_________Reserves for Replacement
_________Total operating expenses____$ 40,000
Equals Net Operating Income (NOI)_____$ 55,000

Please note that lenders always insist on some sort of vacancy factor regardless of the actual vacancy rate of the property. Typically it is the lower of the actual vacancy of the property or the typical vacancy in the subject properties area for similar properties.

In addition, lenders always insist on using some sort of management expense regardless of whether or not the owner self manages the property. A typical factor is around 4% of the effective gross income, but that can vary based on the market and property type. Their logic is that they would have to pay for management if they took back the property.

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.

To calculate the debt service coverage ratio, simply divide the NOI by the mortgage payment(s). Let's assume that there is only one mortgage on the property and it has the following terms:
___$500,000 Loan Amount - 8% Interest - 30 year amortization
_________Annual Payment (Debt Service) = $44,025

It then follows that:

DSCR = Net Operating Income (NOI) of $55,000 = 1.25
__________Total Debt Service of $44,025

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. Conversely the borrower wants as large a loan as possible.

If the loan amount is increased, the debt service requirement will increase as well. Therefore, if the net operating income stays the same but the loan size increases, the DSCR will be lower.

A DSCR of 1.0 is breakeven cash flow. That is because the 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 .95 would mean that there is only enough 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. All lenders frown on negative cash flow, though there are some programs (in select markets) where it is still possible to do the deal with a DSCR of less than 1.0.