Updated February 4, 2016
DSCR formula to calculate debt coverage ratio:
Example of how to calculate the debt service coverage ratio using the DSCR formula:
Your property has a net operating income of $1,000,000 and your annual debt payments are $800,000. Divide the NOI of $1,000,000 by the debt payments of $800,000.
This results in a debt coverage ratio of 1.25.
Most commercial lending guidelines will require a DSCR of 1.25 or higher in order for you to qualify for a commercial property loan.
Because they want to be confident that you can service your debt and have a comfortable cash-flow cushion.
For example, if your DSCR calculation came out to be 1 (let’s say $100,000 in NOI and $100,000 in debt payments), then you only break even.
Your commercial loan application would be turned down since you have no margin for error in covering your debt payments.
The minimum debt coverage ratio also depends on what type of property is involved.
DSCR requirements for multifamily and office properties will normally be around 1.25. But hotel and assisted living facilities will require a minimum DSCR of between 1.4 to 1.5.
This is simply because special-use properties present more risk to commercial loan underwriters.
So you see, the DSCR formula is really pretty simple.
But there is just one problem:
Commercial lenders have their own way to calculate the debt coverage ratio. And you probably aren’t going to like it…
How to calculate the debt coverage ratio like a commercial lender.
The good part is that the DSCR formula stays the same. Lenders still just divide your net operating income by your annual debt service.
Great, so what’s the bad part?
They don’t use the same NOI to come up with the debt coverage ratio.
You see, commercial mortgage lenders have a funny aversion to losing money.
For this reason, they are going to really focus on that debt service cushion we talked about earlier.
The commercial loan underwriter will do this by introducing a new term that you will become very familiar with during the commercial loan underwriting process:
Holdbacks are the added expenses that lenders will add-in to your net operating income.
These extra holdbacks include:
Lenders hold back between 2%-5% even if you have NNN leases.
Differs from lender to lender and can range between 2% to 15%
Required capital for maintenance is often around 3%.
As a result, your lender is probably going to reduce your NOI by about 10% before all is said and done.
And that will make a major difference in your debt service coverage ratio.
So let’s revisit our first example of $1,000,000 in NOI with an $800,000 debt service.
If your lender knocks down the NOI to say, $900,000, then all of a sudden your DSCR ratio goes from 1.25 to 1.12.
Your commercial loan will be declined.
But wait, what if your property is fully-occupied or you don’t even have management fees?
(I told you you probably weren’t going to like this part.)
Doesn’t matter. Every commercial underwriter has a standard set of holdbacks they use when they plug your NOI into the DSCR formula.
These holdbacks will also come up during your commercial property appraisal. (Great!)
So, what if your DSCR ratio is below 1.25?
Don’t panic just yet.
There are a few things you or your lender can do improve your debt coverage ratio.
1. Reduce expenses: Your DSCR is a measure of cash flow. And while it may seem obvious, anything you can do to reduce your operating expenses will go a long way to help raise your debt coverage ratio.
2. Reduce the rate of interest: In some cases your commercial loan lender may be willing to reduce the interest amount. This would lower your debt service and improve your DSCR.
3. Reduce your loan amount: If you are debt service constrained, lenders will often offer you a lower loan amount. While this creates a lower loan-to-value, it also helps get you to an acceptable debt coverage level.
4. Calculate debt coverage with Global DSCR
What is the Global DSCR formula?
The Global DSCR formula is net operating income + personal income divided by annual debt service payments.
Borrowers can often improve their debt coverage ratio by combining personal income along with property income. If your personal finances are strong, it will improve your overall NOI and raise your DSCR.
You will discover that many commercial lenders are opting to use the Global DSCR these days. So it’s a good idea to become familiar with this concept and how it can effect your ability to qualify for a commercial loan.
Any comments or questions? Feel free to let us know in the comments section below: