Investor 101: What is a Debt Service Coverage Ratio?
Why do I need to know about the Debt Service Coverage Ratio?
In the course of purchasing commercial property or large multi-family properties, investors will run into the “Debt Service Coverage Ratio” (DSCR) and wonder what exactly does it do and why is it so important to the lending institutions. First of all, the DSCR is a quick measure of how many times the Net Operating Income(NOI) covers the debt payment. Normally, most lending institutions want the coverage to be between 1.20:1 – 1.25:1 or in other words the NOI must be high enough to cover the debt payment on either an annual level or monthly level by 20%-25% more than the payment. This is to ensure that the property makes enough money to pay the debt with some leeway for one-time expenses. If you have a variable rate, the lending institutions will also “stress test” the calculation to see at what point changes to the interest rate will cause the ratio will fall below what is acceptable for them. Since most banks do not have a long term commercial real estate loan product, this is important for them to know as the loan terms may change every 3 – 5 years.
Now the calculation is critical to whether or not the property can be financed. This is where you have to be the most careful of what you get for information. The lending institutions when analyzing the property will try to obtain the past three years of operating statements from tax returns as they are the most conservative. This is also a good practice for the investor as the information on the income tax returns will show the most conservative income and largest expenses to create the smallest profit to pay taxes on. This can also be the closest you get to the truth. There are some sellers that will give you the actual figures but with some you have to ask questions and potentially see leases and rent rolls for the income to make sense and analyze the expenses very closely. For example, when looking at a multi-unit building whether it’s residential or commercial the electrical expense is sometimes lower than you think but people don’t ask why. Think of your own home and how much you pay for utilities. If the real estate that you’re considering buying has less in utility costs than you do but is significantly larger than your home, the question of why needs to be asked. There are many reasons why it’s ok but you still need to ask. Why is this important? Because the lower the expenses the higher the NOI and if you saw my last blog on CAP Rates, you’ll remember this is a way that the value of the property is manipulated. So watch the expenses and make sure that if there has been vacancies in the building that the income reflects it.
No matter whether or not you see the issues or questionable accounting, the lending institutions will ask you the questions, so you might as well understand as much about the property as possible. The appraisal will also show what is happening and what effect it has on the sales value. But most of all, you want investment property to pay for itself and the DSCR will show you that it can. That’s why it’s important.
As always, I’m always happy to discuss this further if you have any questions.
Next, putting it all together.
Dave Sato
Real Estate Professional
425-213-6411
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