Lenders that provide commercial real estate loans are driven by one key factor: the borrower’s ability to repay the loan. Believe it or not, the strength of the property (return on investment or ROI) often plays a bigger role than the financial strength of the borrower. In making this evaluation, the commercial lender will focus on the Debt Service Coverage Ratio or DSCR.
Given this, your focus should be on the Debt Service Coverage Ratio of the investment property when putting together a loan proposal. It’s a fairly straight-forward calculation – here is how this metric is estimated:
- Calculate the Gross Operating Income. The GOI is the property’s annual gross income minus vacancy rate and non payment. That rate in 2016 was approximately 5% (actually 5.4%).
- Once you have calculated the GOI, you need to determine the Net Operating Income or NOI. The NOI is calculated by subtracting all operating expenses from the Gross Operating Income referenced above. These expenses typically include any costs necessary to maintain the property: upkeep and maintenance, utilities, real estate taxes, etc. This represents the property’s income before financing.
- The next factor necessary is to calculate the Annual Debt Service (ADS). This is the total of all principal and interest payments over the course of the year.
- Finally, we arrive at the Debt Service Coverage Ratio by dividing the Net Operating Income by the Annual Debt Service. Expressed formulaically, DSCR = NOI/ADS
- Now that you understand the calculations involved in expressing DSCR, let’s look at an example of a good Debt Service Coverage Ratio.
Imagine a small apartment building with four units where each unit rents for $1125. That’s a gross annual income of $54,000. Reduce that income by 5% for vacancy and credit loss to arrive at a GOI of $51,300.
Next, let’s calculate the Net Operating Income. For this example, let’s assume utilities, taxes, monthly and annual maintenance costs combine for total annual operating expenses of $27,281. You then subtract this amount from your GOI:
$51,300 (GOI) -$27,281 (Operating Expenses) = $24,019 (NOI)
Now we factor the annual debt service. For this example, let’s assume principal and Interest on a $350,000 loan at 4.1% for 30 years which yields an annual debt service of $20,016. Now, let’s calculate the Debt Service Credit Ratio:
$24,019 (NOI) -$19,998 (P&I) = 1.20 (DSCR)
In our example, this property with this income, expenses and loan costs would yield a Debt Service Credit Ratio of 1.20. What does this mean? This property will generate 20% more income than it needs to make its mortgage payments. For most commercial lenders, this would be a minimum amount they would normally accept as DSCR.
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