Debt Service Coverage Ratio
The most important ratio in all of commercial mortgage underwriting is the debt service coverage ratio. The debt service coverage ratio is defined as the Net Operating Income (NOI) divided by Annual Debt Service on the proposed loan. Debt service is just a fancy word that means the loan payments. When you are computing a debt service coverage ratio, you should not include taxes, insurance or reserves in the debt service number; i.e., you don’t use PITI. The debt service number in the denominator just includes principal and interest. The debt service coverage ratio is normally expressed as two digits to the right of the decimal point; e.g., 1.27 or 1.18.
Debt Service Coverage Ratio = Net Operating Income / Annual Debt Service
In plain English, most commercial lenders want the net rental income of the subject property alone to be able to carry the new mortgage payments. They also insist on a sizable cushion, just in case the owner experiences higher than normal vacancies or higher than normal expected expenses. On a fairly standard deal - let’s say a small shopping center in an average area - most commercial lenders will insist on a 25% cushion. More precisely, they insist on a 1.25 debt service coverage ratio.
In the calculation below, the property generates a net operating income (NOI) of $100,000 per year. The lender will therefore limit the size of his new commercial loan to one whose debt service (payment) is no more than $80,000 per year.
Debt Service Coverage Ratio = Net Operating Income / Annual Debt Service = $100,000 / $80,000 = 1.25
The more uncertain the property’s net income, the larger the cushion that a commercial lender will want. For example, most commercial lenders want a debt service coverage ratio (DSCR) of at least 1.40 on hotels. If the property is leased by Apple Computers for 20 years on a triple-net basis, a commercial lender might be satisfied with a debt service coverage ratio as low as 1.05. By the way, a long-term, triple net lease of a property by a national credit tenant (rated BBB or higher by Standard and Poors') is almost like a bond, and such leases are called Credit Tenant Leases (CTL). Loans on such properties are called CTL financing, and the rates on CTL financing are incredibly low.
HOW LARGE OF A LOAN CAN I GET?
When you apply for a commercial real estate loan, the underwriter of a permanent loan will perform three ratio tests on your loan: the loan-to-value ratio, the debt yield ratio, and the debt service coverage ratio. He will use the loan size that satisfies all three of the ratios. In other words, he will choose the smallest, most conservative loan amount.
Roger Johnson is a commercial loan officer for Wells Fargo Bank. He receives a loan request for a $12 million new permanent loan. He sits down to underwrite the loan. First he tests the loan-to-value ratio. This loan will be secured by a nice office building in San Jose that is being purchased for $16 million. His maximum loan-to-value ratio on such properties is 75% loan-to-value. Multiplying $16 million times 75% gives him a maximum permissible loan of $12 million. So far, everything is looking good. Next he applies a 9% debt yield ratio to the deal. (Don’t worry if you don’t understand the Debt Yield Ratio yet.) Hmmm. The largest loan his bank allows him to make using this ratio is $11.7 million. Lastly, Roger takes the property’s net operating income and computes the largest loan the property can carry that still gives the bank its required 1.25 debt service coverage ratio. That loan amount is $11.2 million. He has three results - $12 million, $11..7 million, and $11.2 million. He therefore informs the borrower that the largest loan that he can approve is $11.2 million - the most conservative of the three loan amounts.
Historically the limiting ratio is often the debt service coverage ratio.
How do you compute the largest commercial loan for which a commercial property will qualify?
- Prepare a Pro Forma Operating Statement (an annual budget) on the property. The bottom line number will be the Net Operating Income (NOI).
- Divide the NOI by the lender’s required Debt Service Coverage Ratio. This will give you the Net Income Available for Debt Service. Let’s shorten this Net Available Income.
- To figure out the largest commercial loan for which you can qualify, take out your financial calculator.
- In the number of payments (N) button, type in the number of years over which the loan is being amortized. Since most commercial loans are amortized over 25 years, type in 25.
- In the interest rate field (I), type in the annual interest rate.
- In the payment field (PMT), type in the Net Available Income from Step 2 above.
- Now ask your calculator to compute the loan amount. This button is often labeled PV for Present Value.
TYPICAL DEBT SERVICE COVERAGE RATIOS
- Multifamily: 1.20
- Office: 1.25
- Retail: 1.25
- Industrial: 1.25
- Self Storage: 1.40
- Hospitality: 1.40
- Business Properties: 1.40
- Assisted Living: 1.50