The debt-service coverage ratio (DSCR) is a key metric in the real estate industry that helps evaluate a company’s ability to cover its debt obligations. Below is a comprehensive guide on how to calculate DSCR and use it for investment analysis and decision-making.
The debt-service coverage ratio (DSCR) estimates how a company’s operating cash flow can cover its annual debt payments.
Lenders use DSCR to appraise loan viability by assessing lending risks and a company’s financial performance. Investors rely on DSCR to manage their portfolios, evaluate investments and mitigate risk.
The debt-service coverage ratio formula divides the company’s annual net operating income (NOI) by its total annual debt service.
| DSCR = Net Operating Income/Debt Service |
For example, if a property generates an annual NOI of $500,000 with a yearly mortgage payment of $400,000, the DSCR formula is applied as $500,000 divided by $400,000, which equals 1.25.
The DSCR is represented by “x” after its value. A DSCR of 1.25x means that the net operating income can cover debt service by 125%.
The debt service coverage ratio formula can vary based on the entity’s calculation. Most adjustments are made to the NOI calculation.
The net operating income (NOI) represents a property’s annual gross income minus operating expenses:
| Net Operating Income = Gross Operating Income – Operating Expenses |
Lenders have different policies when calculating the NOI. Financial institutions usually exclude capital expenditures (CapEx), depreciation, interest and taxes. Calculating the NOI according to a lender’s policies is essential to ensure accuracy and avoid overstating or underestimating the amount of CRE financing a borrower is eligible for.
Total debt service refers to the amount necessary to cover debt obligations. This includes debt principal, interest and any additional fees. Calculating annual debt service can be complex and varies based on factors like loan type, interest rate, debt term and more.
The debt service coverage ratio plays a vital role in commercial real estate loan underwriting:
The debt service coverage ratio is a valuable tool for CRE investors from multiple perspectives:
There is no industry standard for the required debt-service coverage ratio, as it varies by lending institution, loan type and property involved. Commercial banks typically require a minimum of 1.25x DSCR for CRE financing but prefer ratios closer to 2x.
Riskier property types demand higher DSCRs. For example, hotel and self-storage properties require a DSCR of at least 1.40x due to their high turnover and revenue fluctuations.
Access to estimated DSCR values empowers CRE investors to discover various investment prospects. It also aids property owners in evaluating their assets’ financial performance compared to similar properties.
Calculating a property’s DSCR is easy with access to its financial metrics. Since uncovering and aggregating mortgage and income information can be time-intensive, online databases are a swift and reliable source of CRE financing data.
CommercialEdge Research is a dedicated CRE database with over 14 million property records. The platform enables access to accurate financial metrics, including estimated DSCR values and up-to-date loan details. In addition, the platform provides sales data such as the most recent purchase date and price, distressed information, if applicable, and more.
Understanding how to calculate DSCR and recognizing its significance is essential for financial evaluation in commercial real estate. Investors, landlords and brokers can make informed decisions by accessing dedicated databases that offer estimated DSCR values and other key metrics.