- 31 Dec
What is DSCR (Debt Service Coverage Ratio)? How it is calculated? And how CRE Loans or your refinance proposals are affected?
Commercial real estate loan providers are always concerned about getting repaid the capital amount along with the interest and their service charges. However, they focus too much on the borrower’s ability to repay the loan within an agreed time.But this is not the only major factor, as the financial well-being of the borrower is not the only thing which indicates his ability to repay the loan. The strength of the property for which the funds are being borrowed usually becomes a bigger factor while analyzing the ability of the borrower to repay.
For this purpose, they need to know the expected return on investment or ROI of the project or the real estate for which the funds are being borrowed. In simple words, the lender will be confident in giving a loan to any applicant for a property which will generate enough revenues to meet the principal amount payments and interest & service charges. To evaluate the ROI (return on investment) of the project, the loan provider will focus on your DSCR (Debt Service Coverage Ratio).
DEFINITION OF DEBT SERVICE COVERAGE RATION OR DSCR:
Debt Service Coverage Ratio or DSCR typically refers to the amount of cash flow available to meet the annual interest, service charges and the principal payments on the debt. These repayments also include sinking fund payments. In personal finance, Debt Service Coverage Ratio refers to a ratio used by bank loan officers in determining debt servicing ability.
However, you should focus much on the Debt Service Coverage Ratio of the property you are investing in while writing the financing proposal to the bank or any other institution. This is quite easy to calculate and briefly explained in following steps:
Step No. #1: Calculating the Gross Operating Income or GOI of the property:
This is the first factor which needs to be deducted from the property’s annual gross income for calculating the Debt Service Coverage Ratio (DSCR). To calculate Gross Operating Income or GOI of the property you simply deduct vacancy loss and non-payments. Usually, it is 5% of the total expected potential gross income of the property.
The reason for calculating GOI of the property is very obvious as there is a huge probability that the property shall remain vacant sometimes during the year and also, there could be some bad debts.
Step No. # 2: Calculating the Net Operating Income or NOI:
Net Operating Income or NOI is a very key term used to analyze the real estate investments that generate income. Usually, Net Operating Income is equal to all the revenues from the real estate property minus all the necessary operating expenses to run the operating during the year.
NOI is calculated by subtracting all the operating expenses from the Gross Operating Income calculated in Step No. 1 above. These operating expenses include any costs required to maintain the property.
Step No. #3: Calculating the Annual Debt Service or ADS:
Once Gross Operating Income and Net Operating Income are calculated. The next necessary factor to calculate is called Annual Debt Service or ADS. Annual Debt Service is simply the total of the principal repayment, interest and associated service charges during the year. This is quite simple and operational factors do not affect it.
Step No. #4: Calculating the Debt Service Coverage Ratio or DSCR of the real estate property:
When all the three steps above are done, calculating DSCR is just like putting values in a very simple formula. Diving Net Operating Income by the Annual Debt Service gives you the Debt Service Coverage Ratio. i.e. DSCR = NOI / ADS
This simple four-step process helps you calculate Debt Service Coverage Ratio (DSCR) of your real estate property. Let’s calculate Debt Service Coverage Ratio for a property in the following example to make our minds even more clear:
Suppose a small building with ten apartments for rental at $ 1000/- each for the year.
The first step is to calculate the GOI (Gross Operating Income) of the property as follows:
Revenue from all the 10 apartments in the building = 10 * 1000 = $ 10,000/-
To calculate the GOI we reduce the revenue by 5% to deduct the losses from vacancy and non-payments.
GOI = 10,000 – 5% of 10,000 = 10,000 – 500 = $ 9,500/-
Once you have the GOI, the next step is to calculate the Net Operating Income (NOI). For the purpose of Net Operating Income, you need to know the operating expenses during the year. Let’s assume all the operating expenses during the year will be $ 4,250/-. However, the NOI will be calculated simply by deducted these expenses from the GOI as calculated above.
NOI = GOI – Operating Expenses = 9,500 – 4,250 = $ 5,250/-
Now the last step is to put the NOI and the total debt service in the formula to calculate Debt Service Coverage Ratio. Let’s assume that the total debt service is $ 4,100/- for the year including principal payment, interest, and other services charges. DSCR can be calculated now as below:
DSCR = Net Operating Income (NOI) / Total Debt Service = 5,250 / 4,100 = 1.28
Now, what does a DSCR of 1.28 means? This means that the property will generate 28% more income than the liability to repay. Hence, the financial institution would be willing to lend money. Usually, financial institutions accept DSCR above 20% while considering your real estate loan applications.