01What is the debt service coverage ratio?

  • The debt service coverage ratio is a financial ratio that compares a business's cash flow to its debt obligations.
  • It is calculated by dividing the net operating income (NOI) by the total debt service (TDS).
  • The higher the DSCR, the better the cash flow available to cover debt payments.
  • Lenders typically require a minimum DSCR to ensure that borrowers have enough cash flow to meet their loan obligations.

02Step 1: Calculate the net operating income

  • The first step in calculating the DSCR is to determine the net operating income (NOI) of the commercial property.
  • NOI is calculated by subtracting the operating expenses from the gross operating income.
  • Operating expenses include property taxes, insurance, maintenance costs, and property management fees.
  • Gross operating income is the total income generated by the property, including rent and other sources of revenue.

03Step 2: Calculate the total debt service

  • The next step is to calculate the total debt service (TDS) of the commercial real estate loan.
  • TDS includes both the principal and interest payments on the loan.
  • To calculate the TDS, add up the annual loan payments, including both principal and interest.
  • If the loan has a variable interest rate, use the highest potential interest rate to calculate the TDS.

04Step 3: Calculate the debt service coverage ratio

  • Once you have the NOI and TDS figures, you can calculate the debt service coverage ratio (DSCR).
  • Divide the NOI by the TDS to get the DSCR.
  • For example, if the NOI is $100,000 and the TDS is $80,000, the DSCR would be 1.25 ($100,000 divided by $80,000).
  • A DSCR of 1.25 means that the property's cash flow is 1.25 times its debt service obligations.

05Step 4: Evaluate the debt service coverage ratio

  • Once you have calculated the DSCR, it's important to evaluate the result.
  • Lenders typically have minimum DSCR requirements for approving a commercial real estate loan.
  • A higher DSCR indicates a higher cash flow available to cover debt payments, which is viewed favorably by lenders.
  • If the calculated DSCR is below the lender's minimum requirement, it may indicate that the borrower may struggle to meet their loan obligations.

Conclusion

Calculating the debt service coverage ratio is crucial for both borrowers and lenders in assessing the ability of a borrower to repay a commercial real estate loan. By following the step-by-step guide outlined in this article, borrowers can determine their property's cash flow available for debt payments, while lenders can evaluate the viability of providing a loan. It is important for borrowers to have a DSCR that meets or exceeds the lender's minimum requirement to increase the chances of loan approval and successful repayment.

MethodsDetails
Step 1Calculate the net operating income
Step 2Calculate the total debt service
Step 3Calculate the debt service coverage ratio
Step 4Evaluate the debt service coverage ratio
debt service coverage ratio
commercial real estate loan
calculate
step-by-step guide