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Debt Coverage Ratio Formula and Explanation
Lenders require different debt coverage ratios for different properties (and for different borrowers). Find out everything you need to know with our calculator and guide.
What Is DSCR?
A debt coverage ratio, or DCR, is also more commonly known as a debt service coverage ratio (DSCR). We'll abbreviate it simply as DSCR for this article. They're the exact same metric — they just have a slightly different name.
The DSCR metric compares a property’s income with its debt obligations.
Properties with a DSCR of more than 1 are considered profitable, while those with a DSCR of less than 1 are losing money. Most lenders prefer to see DSCRs of at least 1.20x.
In both multifamily and commercial real estate, as well as in corporate finance, the entity or property under consideration generates revenue, or income.
The debt coverage ratio serves as a reliable predictor of a borrower's capacity to repay a loan on time. As a result, lenders typically prefer properties with DSCRs of 1.20x or more, though this may vary based on the financial strength of the borrower and the type of property.
How a Debt Coverage Ratio Relates to Multifamily Loans
Along with loan-to-value and loan-to-cost ratios, DSCR is an essential part of the decision-making process when a commercial or multifamily lender decides whether to issue a loan.
In general, if a property has an abnormally low DSCR, they will have difficulty paying back their loan on time. This is why the majority of lenders like borrowers to have DSCRs of at least 1.15x to 1.25x.
In general, properties with lower LTVs may be able to qualify for funding with lower DSCRs. In addition, ‘safer’ property types may also qualify for loans with lower DSCRs. For example, while risky property types such as hotels or motels might need a 1.30x to 1.50x DSCR to get funding, traditional multifamily or commercial properties (think apartment buildings or shopping centers with an anchor tenant) would typically only need around 1.20x.
Debt Service Coverage Ratio Formula
The DSCR formula is: Net Operating Income (NOI) ÷ Debt Obligations. Despite the apparent simplicity of the formula, an investor will need to make sure they have the correct numbers in order to calculate an accurate debt coverage ratio for a property.
For instance, Net Operating Income/NOI is typically calculated using EBDITA. This means that you should not deduct taxes, interest, or other costs from your NOI calculation before entering it into the DSCR formula.
Now, let’s look at the debt coverage ratio formula in action. Let’s say that a multifamily property had a NOI of $2 million, and annual debt obligations of $1,650,000. In that case, it would have a DSCR of:
$2,000,000 ÷ $1,650,000 = 1.21x DSCR
What Is a Global DSCR?
A global DSCR is when the calculation factors in a borrower’s personal income and personal debts into the equation.
This is typically only done in the case of small business owners, as well as small multifamily and commercial real estate investors, as lenders want additional assurance that these individuals are financially responsible and likely to pay back their debts on time.
If a borrower has a high income and little personal debt, using global DSCR will benefit them, while if they have lower income and higher personal debts, it will make it more difficult for them to obtain commercial or multifamily real estate financing.
In the context of small business commercial property loans, as well as smaller multifamily loans, lenders may use a global DSCR, factoring the borrower’s personal income and debts alongside the property's income and debts. This assessment can be either beneficial or challenging, depending on the personal financial strength of the individual in question.
Business DSCR vs. Property DSCR
For CMBS, life company, HUD multifamily, and other asset-based multifamily loans, the property itself is of foremost importance (though HUD multifamily and Freddie Mac®/Fannie Mae® may take a closer look at a borrower's financials).
However, if you own a small business and would like to use an SBA loan, like the SBA 7(a) or SBA 504 loan, the actual DSCR of your business will be of importance as well. When it comes to SBA 7(a) or SBA 504 loans used for purchasing owner-occupied commercial real estate, the focus is more on the DSCR of your business, rather than the property itself. While it's possible to rent out a certain part of your property to tenants, the profitability of your business takes precedence in such scenarios.
For instance, the SBA requires that 7(a) borrowers have a business DSCR of no less than 1.15x in order to qualify for funding. Keep in mind that your DSCR for a loan calculates not just your current debts, but the annual debt obligation that you will be taking on as a result of your new loan. Also, as mentioned earlier, you will want to use earnings before interest, tax, depreciation and amortization (EBITDA) when you plug your business’s net operating income into the formula.
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