Debt Service Coverage Ratio (DSCR)
The most important ratio to understand when making income property loans is the Debt Service Coverage Ratio. The Debt Service Coverage Ratio ("DSCR") is defined as:
Net Operating Income (NOI)
Total Debt Service
To understand the ratio, it is first necessary to understand the numerator and the denominator. Let’s take a look at Net Operating Income (NOI) first.
The Net Operating Income is the net income from a rental property, left over after paying all of the operating expenses, after paying for professional management (the bank is not going to manage the property itself in the event of a foreclosure), and after setting aside reserves ("Replacement Reserves") to cover such things as the eventual replacement of the roof, the repaving of the parking lot, and the replacement of the HVAC units:
Gross Scheduled Rents: $100,000
Less 5% Vacancy & Collection Loss: $5,000
Effective Gross Income: $95,000
Less Operating Expenses:
Real Estate Taxes
Repairs & Maintenance
Reserves for Replacement
Total Operating Expenses: 30,000
Net Operating Income (NOI): $65,000
Please note that commercial lenders always insist on some sort of vacancy factor, typically 5%, regardless of the actual vacancy rate in an area, in order to cover collection loss. In addition, commercial lenders always insist on using a management factor of 4% to 6% of Effective Gross Income, even if the property is owner managed. Their logic is that they would have to pay for management if they took back the property.
Finally, PLEASE NOTE THAT WE HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.
Next, let’s look at the denominator in the Debt Service Coverage Ratio calculation, Total Debt Service. This includes the principal and interest payments of all loans on the property, not just the first mortgage. NOTE THAT WE HAVE NOT INCLUDED TAXES AND INSURANCE. They were already accounted for above when we arrived at Net Operating Income (NOI).
To calculate the Debt Service Coverage Ratio, simply divide the Net Operating Income (NOI) by the mortgage payment(s). For the sake of simplicity, let us assume that there is only one mortgage on the property:
$500,000 First Mortgage
6.5% Interest, 25-years amortized
Annual Payment (Debt Service) = $40,512
Debt Service Coverage Ratio (DSCR) =
Net Operating Income (NOI) = $65,000
Total Debt Service = $40,512
DSCR = 1.60
Obviously, the higher the DSCR, the more Net Operating Income is available to service the debt; i.e., make the payments. From a lender’s viewpoint, it should be clear that they want as high a DSCR as possible.
The borrower, on the other hand, wants as large a loan as possible. The larger the loan, the higher the debt service (mortgage payments). If the net operating income stays the same, and the loan size and therefore the debt service increases, then the lower the DSCR will be.
Life (insurance) companies and CMBS lenders are very conservative and aways require a 1.25 to 1.35 Debt service Coverage Ratio (DSCR). On hotels, a Debt Service Coverage Ratio of 1.40 to 1.45 is common. This means that their loan-to-value ratios are low.
Savings and loans (S&L’s) and credit unions generally only require a 1.25 Debt Service Coverage Ratio, and sometimes they will accept a DSCR as low as 1.10.
A Debt Service Coverage Ratio 1.0 is called a breakeven cash flow. That is because the Net Operating Income (NOI) is just enough to cover the mortgage payments (debt service).
A Debt Service Coverage Ratio of less than 1.0 would be a situation where there would actually be a negative cash flow. A DSCR of say .95 would mean that there is only enough Net Operating Income (NOI) to cover 95% of the mortgage payment. This would mean that the borrower would have to come up with cash out of his personal budget every month to keep the project afloat.
Generally commecial lenders frown on a negative cash flow. Life insurance companies ("life companies"), commercial banks, and conduits typically require a 1.25 Debt Service Coverage Ratio or higher. In plain English, this means that the property's projected Net Operating Income ("NOI") must be 125% of the annual loan payment on the commercial loan being sought. With a 1.25 Debt Service Coverage Ratio, there is a 25% cushion. With a 1.25 Debt Service Coverage Ratio, the projected Gross Income of the property could fall short, and the Operating Expenses could be materially higher, but the property might still have enough income to make the lender's loan payments, while still keeping the property in good repair.
Some commercial lenders will allow a negative cash flow if the loan-to-value ratio is less than around 65%; the borrower has strong outside income (global income), such as a physican; and the size of the negative cash flow is modest. Modernly, sub-prime, non-prime, and hard money lenders regularly allow material negative cash flows, assuming the borrower has enough global income.
There is one, very rare exception to the general rule that commercial banks will always insist on a 1.25 Debt Service Coverage Ratio. There are three conditions that must be filled.
- The high-net-worth borrower must have a banking relationship (maintains large cash balances with the bank) with the bank, or he promises to develop one as a condition of the bank making the loan; and
- The borrower is buying the property, and he is putting at least 35% to 40% down in cash; and
- The property is a prime-prime commercial property selling at a ridiculously low cap rate.
Under these rare circumstances, a bank might make a purchase money first mortgage of 60% or 65% of the purchase price, even if the Debt Service Coverage Ratio is significantly less than 1.0. A Capitalization Rate ("Cap Rate") is nothing more than the return on his money that an investor would earn if he bought an income property for all cash.
As a general rule, the lower the cap rate, the more desirable the property. For example, commercial properties across the street from Central Park are arguably some of the best located properties in the entire world. Among the wealthy, such properties are highly coveted. It would not be surprising for such properties to sell at 2% to 3% cap rates. In other words, an investor might pay $300 million for a small apartment buiding across from Central Park, and he might only receive $6 million per year in net income. That's a return on just 2% on his money. Why would an investor be content with a return of just 2% on his money? The world could practically melt-down, yet he would still be able to sell his building in a heartbeat. Such is the lust of other wealthy investors to own property across from Central Park.
Now you and I are never going to be allowed to finance an apartment building across from Central Park, but we will get the chance to finance an office or industrial condominium. Such properties are bought and sold on a regular basis at ridiculously low cap rates in the range of 4% to 5%. At today's (9/28/18) bank commercial mortgage rates of 6.25%, such properties, at a 1.25 Debt Service Coverage Ratio, will only carry a new mortgage of 45% loan-to-value.
Does the bank (outside of an SBA lender) expect the buyer to put 55% of the purchase price down in cash? This situation is where a rare breath of common sense comes in. If the buyer is a big bank depositor and he is putting 35% to 40% down in cash, a small, local bank might finance the balance of the purchase price, even though the Debt Service Coverage Ratio is well less than 1.0.