If you are new to commercial real estate financing, you will undoubtedly find that there are a number of important terms and ratios that one should understand when evaluating a property. One of these terms is "debt service coverage ratio," otherwise known as DSCR. DSCR is commonly used by commercial lenders as the benchmark to determine whether a property's cash flow will support the loan request that the lender is considering for financing.



How to Calculate Debt Service Coverage Ratio

The debt service coverage ratio is calculated as follows:

DSCR = Net Operating Income / Annual Debt Service

What Does the DSCR Mean?

Let's say that your DSCR is 1. This means that your property's cash flow is just enough to make your annual mortgage payments. If it is less than 1, that means your property is not generating enough cash flow to support the debt payments on the property. In such a case, this negative cash flow would require the owner of the property to reach into his/her own pockets to cover the difference. If the DSCR is greater than 1, then your property's cash flow should be sufficient to cover the annual debt service.

How Do Lenders Evaluate DSCR?

Put simply, the higher the debt service coverage ratio, the lower the risk to the lender. Most commercial lenders in the industry are comfortable with underwriting loans with a DSCR of 1.2. A DSCR of 1.2 means that your property's cash flow is generating at least 1.2 times the annual debt service on your property. Converting this to dollars means that for every dollar that you are spending towards your debt payments, you are bringing in $1.20. To the lender, this means you have more than enough net cash to support your mortgage payments.

Why is it Important to Understand DSCR?

It's important to understand DSCR because what you think is your DSCR might not be what the lender thinks it should be. Let's say, for example, that you submit your loan application to a commercial lender who requires a DSCR of 1.2. You believe your property meets that requirement. But in the lender's review of the property's historical operating statements, they find that there are several revenue items that are not common occurrences, or several items of expenses that should have been included in your operating expenses. What lenders often do is "normalize" the expenses and income. When this happens, their calculation of DSCR may be much lower than you had anticipated, thus making your property ineligible for financing by that lending institution.

Make Sure You Know Your Property's DSCR

Because the DSCR is such a critical factor in a lender's decision to approve a loan, as a commercial real estate investor, you may want to seek the assistance of a qualified commercial mortgage or finance broker who can help you pre-underwrite your loan scenario BEFORE submitting the application to any lender. The pre-underwriting analysis will not only help you prepare and address any obstacles that may come in your path, but the analysis will also demonstrate to the lender that you are serious about your application and that you have done your due diligence. There is so much capital available for commercial real estate investors. Just be sure to do your homework and the financing will follow!