What is Debt Service Coverage Ratio and Why is It So Important?
Sep 03, 2014
Debt Service Coverage Ratio (DSCR), otherwise known as the debt coverage ratio (DCR), is one of the main tools that lenders use when deciding whether to make a particular loan.
A simple example of how DSCR is calculated is:
Net Operating Income / Total Debt Service Costs
In other words, this ratio compares a company's available cash with its current interest, principle, and sinking fund obligations. The debt service coverage ratio is important to both creditors and investors, but creditors most often analyze it. Since this ratio measures a firm's ability to make its current debt obligations, current and future creditors are particularly interest in it.
Unlike the debt ratio, the debt service coverage ratio takes into consideration all expenses related to debt including interest expense and other obligations like pension and sinking fund obligation. In this way, the DSCR is more telling of a company's ability to pay its debt than the debt ratio.
The debt service coverage ratio measures a firm's ability to maintain its current debt levels. This is why a higher ratio is always more favorable than a lower ratio. A higher ratio indicates that there is more income available to pay for debt servicing.
A ratio that is above 1/1 would show that the borrower has excess income to meet continuing obligations, plus the payments any loan that the lender is contemplating giving. A ratio below 1/1 would mean that there is not enough income to support the proposed debt, along with existing obligations.
A vast majority of lenders describe themselves as “cash flow” lenders. These lenders would include pretty much all the banks, credit unions, life Insurance companies, etc. In order to get a loan from a cash flow lender, a ratio in excess of one is a requirement.
Most borrowers who find themselves with a DSCR below one end up with a private money loan. This is often called "Hard Money" and rightfully so as the rates and fees are significantly above that of a cash flow lender.
Different banks have different DSCR requirements and depending upon the specifics of any transaction, the required DSCR could be higher or slightly lower. Generally speaking, those lenders that offer the lowest rates would like to see a higher DSCR than those lenders with higher rates. Not always, but in general the lower the rate the harder it is to get the loan. It is a reasonable assumption that most national banks look for a DSCR approximating 1.25/1 at a minimum.
Occasionally a Small Business Administration (SBA) lender will consider a loan to a borrower who has existing financials that show a DSCR below 1/1 if the borrower has a reasonable projection and can show the ability to make loan payments. An example of this would a business that purchases a property to expand their existing business. The income to pay the loan will come from the new location and would not be shown in existing financials.
With investor properties, some lenders look at two DSCRS– one for the property being lent upon and another that would include the property and the borrower.
The DSCR for the borrower and the property is known as the Global DSCR or Global cash flow. The common practice is for a lender to require a Global DSCR to be slightly higher than the property DSCR. An example would be if the DSCR for the property were 1.25/1, a lender would also like to see a global DSCR of 1.35/1. When dealing with owner user real estate the global cash flow is the only relevant DSCR. There are some exceptions to this rule, but they will cost money.
Why this is important
The debt coverage ratio impact a borrower's ability to get a loan at reasonable terms and conditions. Private money rates can be at least three percent higher than conventional rates and usually significantly more.
What you can do about it
- Prior to applying for a loan pay off all your credit cards. Banks often take a percentage of your total balance and add it to your total debt service. This amount varies from lender to lender but can be up to three percent per month of your total balance. For example, if you have $10,000 in credit card debt, a lender would assume $300 in monthly payments.
- Buy or refinance your commercial real estate before you make any purchases that require monthly payments. Every dollar in monthly payments that a borrower has is added to the denominator.
- To the vast majority of lenders the most important year for the DSCR is the last year that they have tax returns or audited financial statements. So, if you are planning on purchasing or refinancing commercial real estate in 2014, you want your 2013 taxes to look good even at the expense of a prior year's tax return.
Note for Investor Properties
- Be sure to review all your expenses for the previous years. If there are any expenses that are one-time expenses not to be repeated you should notify the lender as this money could be added back to your cash flow.
- Try to time any leases so that they do not expire shortly after your loan term ends. There are two reasons for this:
a. Banks like to see a long-term cash flow when making a loan.
b. Hopefully the current income for the property will be higher than the previous income.
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Written by: Hans Hansson
Hans Hansson is President of Starboard TCN Worldwide Real Estate Services as well as a member of the Board of Directors for TCN Worldwide Real Estate. Hans has been an active broker for over 29 years in the San Francisco Bay Area and specializes in office leasing and investments. If you have any questions or comments please email email@example.com or call him at (415) 765-6897. You may also check out his website, www.commercialspacefinder.com.