The Debt Service Coverage Ratio (DSCR) is a critical metric used in commercial real estate lending to assess the ability of a leased property or business to generate enough cash flow to cover its debt obligations. DSCR is an essential factor Enact Partners uses to help evaluate the risk associated with funding a particular commercial property or project.
Most lenders, especially traditional bank lenders, want to see that the property’s cash flow can cover the loan payments with additional cushion to ensure some measure of profitability as well as cover unexpected repairs, loss of tenants, etc.
How DSCR is Calculated
DSCR = Net Operating Income / Total Debt Service
The result of the DSCR calculation is usually expressed as the whole number “1” followed by a two decimal number, such as “.25,” meaning the Net Operating Income (NOI) is 1.25 times the Total Debt Service (TDS).
In our calculation, Net Operating Income equals the property’s Gross Income minus vacancy factors and Operating Expenses.
- Gross Income includes rent and any triple net (NNN) expense reimbursements from tenants. NNN expense reimbursements represent the share of the landlord’s property taxes, insurance, and utilities for which tenants are responsible, net of property taxes, net of insurance, net of utilities (thus the term, “triple net”).
- Operating Expenses are all expenses directly related to the property, such as property taxes, insurance, utilities, repairs, common area maintenance, property management fees, and reserves. Operating expenses do not include loan payments.
Total Debt Service refers to the total amount of real estate debt payments that a borrower must make within a defined period (typically on an annualized basis) for the loan on the specified property. Total Debt Service includes both the principal repayment and the interest payments on the loan or debt.
Interpreting the Results
After calculations, a DSCR of “1.25x” would mean the project’s cash flow for a given period is expected to be 1.25 times the debt service. After paying debt service (represented by the “1”), the remaining “0.25” would be excess cash flow to the owner.
Residential loans typically require at least a DSCR of 1.20x to 1.25x using the projected NOI, the Loan Amount, and Principal & Interest (P&I) payments for a 30-year amortization. Some lenders might go as low as 1.00x, but that’s rare.
Commercial loans typically require a DSCR of 1.35x using the projected NOI and Total Debt Service on a 25-year amortization.
How DSCR Helps Evaluate Risk
The DSCR provides lenders and borrowers a clear picture of whether the property’s income is sufficient to meet its debt obligations.
- A high DSCR indicates that the property generates enough income to comfortably cover its debt payments, reducing the risk of default.
- A high DSCR also can be an attractive sign for investors looking for stable and low-risk investments.
- A low DSCR signals a higher risk of potential default, which may lead to lenders either declining the loan or requiring additional collateral or higher interest rates to compensate for the risk.
Many banks and traditional lenders have specific DSCR thresholds that borrowers must meet to secure financing. These thresholds serve as benchmarks to determine whether a property’s income stream is strong enough to support the loan amount being requested. Meeting the required DSCR is often a prerequisite for securing commercial real estate financing.
How Enact Partners Uses DSCR
Most private lenders only look as Loan-to-Cost (LTC) and Loan-to-Value (LTV) ratios to evaluate risk. Enact Partners looks at those factor plus uses DSCR as a measure of ensuring the borrower will be able to get a bank to pay off the loan once the project is completed. We also work with borrowers to get an overview of their whole project, which includes an assessment of planning and preparation vital to success.
Having direct access to Enact Partners and our decades of collective real estate development and lending experience is a critical value-add for borrowers. Our holistic lending approach allows us to focus not only on specific metrics like DSCR, but also on borrower reputation, project merits, and other aspects related to potential profitability and the borrower’s ability to pay back a loan. Thus, DSCR is an important metric but not the only one we use to ensure project viability and safeguard the interests of Enact Partners, borrowers, and our investors.
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