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Knowing how to calculate a debt service coverage ratio -- or DSCR -- is an important skill for all commercial real estate investors. After all, this is one of the key equations lenders use when deciding whether to approve your company for a new loan. With that in mind, rather than just applying and hoping for the best, doing your own calculation of dscr beforehand will give you a better idea of the result you can expect.
To that end, below is an explanation of what a DSCR is and why it matters in the lending process as well as an example of how you can do one of these calculations on your own. You'll learn how the ratio your company receives can make or break your chances of being approved for additional financing.
What is a Debt Service Coverage Ratio (DSCR)?
A DSCR is a financial calculation that's used in a variety of contexts, including corporate and governmental finance as well as commercial real estate. In the real estate world, this calculation is used to measure a company's cash flow against its current debt obligations.
Typically, lenders look at a company's debt service coverage ratio when deciding whether to approve them for a loan. This calculation gives lenders a sense of whether the company will be able to pay back the loan and any interest in a timely manner. Clearly if debt obligations outweigh a company's cash flow, this becomes problematic for the DSCR ratio. Each lender will have their own DSCR requirements, or even a minimum DSCR. In general, the higher the ratio is, the more comfortably the company will be able to handle taking on the new loan.
Why is the DSCR important?
Put simply, every time a lender issues a loan, they're taking a risk. There's always the chance that you, as the borrower, will default on the loan and allow it to turn into one of your debt obligations. However, lenders want to try and minimize that risk for the borrower as much as possible, especially when they're dealing with real estate investors, who are likely balancing payments for more than one loan at a time.
With that in mind, lenders look toward calculations like the service coverage ratio to provide them with the reassurance that your company has generated -- and will likely continue to generate -- enough revenue to cover the cost of a new loan plus interest. Essentially, they want to see that your company has enough cash on hand to comfortably cover the loan payments and continue to run your business, even if a property sits vacant for a while or you lose money on a flip.
How to calculate DSCR
Each lender uses a slightly different method to calculate your DSCR, so you'll want to be sure to ask exactly what calculations you'll be subject to when applying for a new real estate loan. However, in general, the formula for calculating a debt service coverage ratio is:
DSCR = Net operating income / Annual debt service
In business, your net operating income (NOI) is your net income, plus any taxes or interest payments. Here, your net income is the amount of revenue you brought in this year, minus any expenses you incurred during that time. Your net income is also the final number that appears on a profit and loss statement.
Meanwhile, your annual debt service stands for the total amount of debt that your business owes during the same time period. In this case, you'll find this number by adding up the total debt payments -- including principal and interest amounts -- that you either have paid or plan to pay throughout the year. Usually, when your lender does their calculations, they account for all of your existing debts, plus the loan you intend to take on.
Global debt service coverage score
Some lenders will use what's known as a global DSCR in place of the standard debt service coverage ratio. If your lender uses this calculation, they will not only take into account the income and debts held by your business but also your personal financial history. This could include any salaries you receive from other jobs, as well as any mortgage or student loan debts you have to your name.
In other cases, your lender may even want to include the income and debts of any business partners or guarantors you have in order to get a global -- or combined -- picture of your network's overall financial health before deciding whether to grant you a new loan.
What is a good DSCR?
Debt service coverage ratios are always expressed as a ratio that's less than, equal to, or above one.
Ratios below one indicate that your company currently isn't making enough money to cover all of its current debts. For example, a final ratio of 0.88 would indicate that your company is only making enough money to cover 88% of its financial obligations. At that rate, it's very unlikely your company would be approved to take on an additional loan.
Conversely, a ratio of one would indicate that your company is making just enough money to break even, while a ratio above one would show that your company is making a profit after all its debts have been paid.
For instance, a ratio of 1.2 would show that the company is able to generate a 20% profit after all its debts have been paid. A business with this ratio is highly likely to be approved for additional financing.
Generally, anything above one is considered to be a good DSCR. Though, the higher the ratio is, the better. Each lender will have their own requirements for what they consider an acceptable ratio. However, as a practical example, the U.S. Small Business Association (SBA) requires a DSCR of 1.15 or higher in order to be approved for one of its loans.
Calculating DSCR: a real-world example
Now that you know how to calculate the DSCR for your business, it's important to see how this calculation might play out in a real-world example. Your best bet might be to use a coverage ratio calculator to help you with the calculations, but we'll show how to do them step by step:
Step 1: Find your net operating income (NOI)
In real estate, your net operating income (NOI) is often expressed with this equation:
NOI = (Gross potential income - Vacancy costs) - Operating expenses
In this example, let's suppose each of those figures had the following values:
- Gross potential income: $100,000.
- Vacancy costs: $10,000.
- Operating expenses: $1,000.
Given those numbers, your NOI equation would look like this:
NOI = ($100,000 - $10,000) - $1,000
NOI = $90,000 - $1,000
NOI = $89,000
Step 2: Find your annual debt service
To calculate your total debt service on a property, you need to add together your total principal and interest payments on the loan. For this example, suppose, you took out a loan amount of $1.3 million at an interest rate of 3.5% over a 30-year loan term.
Since mortgage interest is amortized, the calculation for it can get a bit complicated, but the equation looks like this:
Debt Service = Yearly Loan Payments (Principal + Interest)
Debt Service = Loan Amount * Interest Rate / 100 / [1 - (1 + Interest Rate / 100 / 12) (-12 * Loan Term) )]
Given the above numbers, this property's debt service equation would be:
Debt Service = $1,300,000 * 3.5 / 100 / [1 - (1 + 3.5 / 100 / 12) (-12 * 30) ]
Debt Service = $70,050.97
Step 3: Calculate your debt service coverage ratio
Once you have those two numbers in hand, calculating your DSCR is simply a matter of dividing your net operating income by your debt service.
DSCR = NOI / Debt Service
Using the numbers from above, the final calculation would look like this:
DSCR = $89,000 / $70,050.97
DSCR = 1.27
In this example, the company would likely be approved for their loan because the numbers show that a 27% profit would likely be made after all the debts had been paid.
The bottom line
From performing a cash flow analysis to calculating the loan-to-value ratio, lenders use many different equations in determining whether to approve commercial real estate investors for a loan. At the end of the day, a property's debt service coverage ratio is just one of them. However, it's often important enough to make or break their decision.
With that in mind, use this information to calculate DSCR on your own and gauge your chances of being approved. If you need to, you can always find ways to cut costs in your business in order to improve your ratio before applying.
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