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How To Calculate DSCR: Debt Service Coverage Ratio for Commercial Loan Approval

Basis of the Commercial Loan-Calculating the Debt Service Coverage Ratio

One of the most important factors used to determine the fund-ability for a commercial mortgage request is the Debt Service Coverage Ratio, commonly referred to as the DCR or DSCR.

The DSCR is a ratio used to determine the amount of debt that can be supported by the revenues generated from the commercial property. Very simply it’s the net income generated by the commercial building divided by the new commercial loan payment.

How the DSC relates to Commercial Mortgage Lending

One of the main reasons commercial loan modification or commercial loan requests are denied is that the property does not support the lenders or special servicers minimum debt coverage requirements.

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 lenders use the actual expenses plus additional line items, such as, off-site management, vacancy, replacement reserves, repairs and maintenance, etc. Commercial lenders add these numbers to the expenses should the borrower default.  They must know the entire cost of taking back the property in event of a default.

How to calculate the DSCR

Here’s an example of how a commercial mortgage lender calculates the DSCR. The lender holdbacks are not actual expenses, but they are deducted from the property’s gross income for underwriting purposes. Example assumes a 186 unit property multifamily property.

Gross Rents $1,180,000
Other Income $    20,000
Total Annual Gross Income $1,200,000
Less 5% Vacancy & Collection Loss $     60,000
________
Effective Gross Income: $1,140,000
Real Estate Taxes $     75,000
Property Insurance $     28,000
Repairs & Maintenance $     45,000
Janitorial $     16,000
Utilities $   124,000
5% Off Site Management Reserve $     60,000
Replacement Reserves
$200 Per Unit @ 186 Units
$     74,400
Total Operating Expenses: $422,400
Net Operating Income (NOI) $717,600

 

The NOI has now been calculated and the next step is to determine the loan payment.  Long term debt is usually principal and interest and you can assume interest only payments on bridge or acquisition financing. The Taxes and Insurance numbers are accounted for in the expenses portion of the above example.

To calculate the DSCR, divide the net operating income (NOI) by the commercial mortgage loan payment.

Commercial Loan Purchase Price: $5,000,000 First Mortgage
Interest Rate: 10.0%
Term: interest only
Annual Payments (Debt Service) = $500,000

Now we can calculate the DSCR:
DSCR = Net Operating Income (NOI) = $717,600
Total Debt Service $500,000
DSCR = 1.44

Cash flow generated by the property will cover the new commercial loan payment by 1.44 x. Because most lenders will require a minimum DSCR of 1.20x this loan is eligible for competitive financing.  So, why do I use a rate of 10% to calculate the debt service?  Your not going to find quick close bridge financing that’s less than 10%.  Most opportunistic funds typically are seeking internal rates of return (IRR) of 18-25%.  If you plan on acquiring distressed commercial property at a discount you will need quick close bridge financing and you will not get competitive market rates until you take over the target asset, stabilize it for twelve months and get it into position for a traditional commercial lender refinance.

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.

Most new lenders are starting to use what’s now being called a global DSCR. A global DSCR is a ratio that combines both personal and property income and expenses when calculating the DSCR. This allows for properties with weak cash flow, or a property in a low CAP area, to still qualify for a private equity commercial loan provided the borrower has additional income and assets to add the property’s NOI.

Problems always become opportunities when the right people come together. – Blaise Dietz-CCP

 

Types Of Commercial Loan Financing

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Church Loans

Business Acquisition or Franchise Start-up

Hard Money Loans – Get funding now!

Medical Practice Loans: Based on cash flow – no real estate required


Pam Knight
, Commercial Specialist
512-452-4009      Fax: 512-452-4009

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More information about commercial business loans:

Finance Commercial Real Estate
Investment Banking Options
Self-Directed IRA Investing
How To Calculate Commercial DSCR-Debt Ratio