When investing in real estate, a property’s net operating income receives ample attention. The NOI calculation tells the investor how profitable an investment is. This calculation serves other purposes as well. For example, it is a fundamental component in other critical ratios, such as the return on investment, the cap rate and the debt coverage service ratio DSCR. Lenders typically have strict DSCR requirements. In fact, the DSCR can make or break your ability to obtain financing. More than that, it tells you how risky the investment is to you. Understanding how to calculate debt service coverage ratio up front helps you to more successfully focus your property search on suitable investments.
What Is DSCR?
The debt service coverage ratio examines the property’s cash flow in relation to its ability to service its debt obligations. The debt obligation includes the principal and interest payment. On a deeper level, the debt service coverage ratio signals the financial health of the investment to the investor.
It also indicates credit risk to the lender. How easily can the property’s income cover the principal and interest payments? Generally, a lender will approve a lower loan amount if its DSCR requirement is not met and if no other relevant factors are at play. Doing so reduces the lender’s exposure to risk by establishing more manageable debt payments in relation to the NOI. In addition to lowering the loan amount, other strategies can be used to align the DSCR with the lender’s underwriting requirements, and we look at those below.
How to Calculate DSCR
To calculate DSCR ratio, two components are used. These are the net operating income and the annual debt service obligation.
While a real estate agent may market a property using a projected or future NOI, such as after rents have been increased to the market rate or stabilized, many lenders look at the current NOI when calculating the DSCR. The current net operating income uses the actual expenses and the current rents with the current occupancy rate. Capital expenditures, such as major repair or upgrade costs, are not included in the operating expenses.
The annual debt service is 12 months of the principal and interest payments. Do not include the escrow payment for the property taxes and insurance here. When you calculate DSCR, the property taxes and insurance are included in the NOI calculation.
Once you know the net operating income and the annual debt service obligation, you can calculate the debt service coverage ratio. Simply divide the property’s NOI by the annual debt service. Here is the simplified DSCR calculation:
DSCR = (NOI / ADS)
Interpreting the DSCR Calculation
Generally, the DSCR will range between 0.85x to more than 1.3x, but it can also fall far outside of this range. What does the DSCR indicate, and what is a good DSCR?
If the net operating income equals the debt payments, the property is making just enough net income to cover the principal repayments and interest charges. This may be expressed as a 1:1 ratio or 1.0x.
If the net operating income is lower than the annual debt service, the DSCR will be below 1.0x. The lower the DSCR is, the greater the credit risk to the lender. A ratio below 1.0x means that the property cannot service the debt.
If the NOI is higher than the annual debt service, the DSCR is greater than 1.0x. While this indicates that the property generates enough income to cover the debt payments, simply having a DSCR greater than 1.0x may not be sufficient to qualify for financing.
A 1.01x DSCR, for example, indicates that the property just barely covers the debt. Something like a dip in occupancy rates or a capital expenditure can result in hardship for the property owner and increases the risk of foreclosure and loss to the lender.
A 1.01x DSCR means that NOI covers 101% of the annual P&I payments. A 1.3x DSCR, on the other hand, means that the NOI covers 130% of the annual P&I payments. In the latter scenario, the buyer has considerably more leeway to cover unexpected expenses or a dip in income without impacting his ability to pay the principal, interest taxes and other expenses.
Each lender establishes a minimum DSCR for loan approval. For example, a lender may require a 1.2x DSCR for a multifamily property or a 1.25x DSCR for a multi-unit office building. Some lenders may have a 1.3x to 1.4x DSCR for certain property types or properties in specific locations. In some situations, a lender may agree to a DSCR that is lower than required if there are mitigating circumstances. For example, if the borrower has a large amount of liquid assets and the property has considerable upside potential, the lender may approve the loan. This is most common with a hard money loan.
Resolving a Low DSCR Situation
There is no such thing as a DSCR that is too high. A higher DSCR indicates that the property’s income can more comfortably service the debt. A low DSCR, however, is problematic. There are a few ways to resolve a low DSCR situation.
Because the DSCR is a component of the NOI and the ADS, one or both of these factors can be adjusted to achieve an acceptable DSCR. For example, some figures on the NOI may be massaged, such as by identifying a management company with a more affordable rate. If a property is currently operating with below-market rents, the seller may be able to increase rents to support a higher NOI and DSCR before closing.
The annual debt service is 12 months of the principal and interest payments. These payments are a product of the loan amount, interest rates and the loan term. Each of these factors can be analyzed to achieve an acceptable DSCR. For instance, the seller may agree to come down on the sales price, or the buyer could make a larger down payment. The buyer may also be interested in buying down the interest rate or agreeable to a longer loan term or a term with a balloon payment. Depending on the circumstances of the specific scenario, several of these strategies may be combined.
An Example of the DSCR Formula
As an example, a multi-tenant office building has a net operating income of $80,000. The sales price is $800,000, and the buyer is making a 30% down payment. So, the loan amount is $560,000. Assume a 9% interest rate with a 20-year term. The annual debt service obligation, including principal and interest, is close to $60,500.
The DSCR is $80,000 / $60,500, or 1.32x. This is a good DSCR that may meet many lenders’ underwriting requirements.
If the lender has a 1.35x DSCR requirement, however, the scenario fails. If the borrower increases the down payment by $20,000, the new loan amount is $540,000. The annual debt service is $58,308. The DSCR is then 1.37x.
If the borrower does not have additional funds to contribute, a longer term length could be considered. Using a 25-year term with a $560,000 loan amount, the annual debt service obligation is $56,400. The DSCR is then 1.41x.
Explore Your Financing Options Today
The DSCR plays a key role in real estate financing. Understanding how it is calculated is essential for making a savvy investment selection and negotiating reasonable terms with the seller. In addition, understanding what the DSCR indicates and how it can be adjusted, if needed, can make or break a transaction. To explore your financing options, contact Macoy Capital today.
