Debt service coverage ratio (or DSCR) is one of the key metrics utilized in evaluating commercial real estate transactions and finance decisions. At a basic level, the ratio operates in the same way for real estate companies as it does for individuals paying down a mortgage: it is the net income available to service a loan, per unit time. Whether an individual or a company, the ratio is used as a measure of “credit worthiness” or, conversely, as a measure of risk for the prospective loan issuer.
In the case of commercial real estate lending, the ratio can be expressed as DSCR = NOI / Total Debt Service, where NOI is the familiar Net Operating Income figure (Effective Gross Income less Operating Expenses) and Debt Service captures both interest payment and, for amortizing loans, scheduled repayment of principal for the unit of time being considered.
A debt service coverage ratio of greater than 1 indicates that property cash flows are sufficient to service the loan, however most commercial lenders require a significantly higher minimum DSCR in order to originate a loan, typically in the range of 1.15-1.35. Non-bank lenders, or “hard money lenders”, may be somewhat more forgiving of a DSCR closer to 1. In either case, the DSCR at which lenders are willing to lend will depend somewhat on market conditions and macroeconomic trends, all factoring into the perceived risk of the particular loan; in a healthy market during an economic upswing, a lender may be willing to lend at a DSCR closer to 1. Other aspects of the borrower’s situation may also factor into the DSCR required by the lender, such as their track record in sustaining NOI and making timely payments on past loans.
Debt service coverage ratio is an extremely important metric not only in our underwriting, but in an investor’s decision-making process. Since the senior lender is always first to get paid, DSCR indirectly tells us how much cash is left for equity investors during a certain time period.
i – Trends in Commercial Mortgage-Backed Securities | Frank J. Fabozzi, Yale University