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Some calculations in real estate do not relate to profit but to debt- more specifically, your ability to repay it. Debt service coverage ratio is a calculation made by lenders, but it is helpful to know how it works and how to work it out yourself to understand more about the position you are in for a potential loan.
This guide is here to help property investors gain a better understanding of what debt service coverage ratio means and how it will affect their investments. It covers the definition of the term, how it is calculated, what factors impact the outcome, and how it is leveraged in the world of real estate.
What Is Debt Service Coverage Ratio?
Debt service coverage ratio (DSCR) is a calculation most often used in commercial real estate. It measures an investor or firm's ability to cover their current debt obligations based on cash flow.
It looks at how much income is generated compared to the debt owed- and the debt that would be owed if the loan were approved.
Calculating DSCR is a way for lenders to ensure the person they are lending to has enough to pay them back the principal and interest payments. Otherwise, they are unlikely to move ahead with the approval. It is also used to establish the financial health of a company- especially one that is leveraged with a lot of debt.
The measurement is expressed as a single number, not a percentage. A DSCR of one means an equal amount of debt to income. Anything higher than one means there is more cash flow coming in than is owed in debt. If the DSCR calculator comes back with a number below one, this means the debt service exceeds cash flow, and the person or firm in question is over-leveraged with debt obligations.
How Is a Debt Service Coverage Ratio Calculated?
How exactly are DSCR calculations made?
Put simply, lenders look at net operating income- a.k.a. how much money a firm or property company earns before tax but after operating expenses- and their total debt service, meaning how much debt is leveraged against them.
Formula Used to Calculate DSCR
The DSCR formula looks like this:
Debt Service Coverage Ratio (DSCR) = Net Operating Income (NOI) ÷ Total Debt Service
Let's take a closer look at what each of the variables means.
Net Operating Income
Net operating income in real estate is the term used for the profitable earnings a property generates after expenses.
In most cases, income is generated primarily through rental payments, but commercial properties may also bring in earnings in other ways. All rental income and other income are combined to give the gross operating income.
Next, certain operating expenses are considered. These include maintenance, HOA fees, property management fees, insurance costs, and other costs (excluding interest payments and taxes).
This total is taken from the gross operating income to give the net operating income.
Total Debt Service
Total debt service just means the combined current debt obligations. To calculate total debt service, all the ongoing loans, their balances, and how much the repayments are each month are combined.
Lenders look at the monthly debt obligations a property company or solo investor already has to find out what percentage of their earnings are already going to debt.
By adding the debt they would have if their loan is approved, lenders can decide whether or not they have enough income to support the loan payments.
What Factors Affect Debt Service Coverage Ratio in Real Estate?
Your DSCR is only really impacted by your incomings and expenses- unless you have existing debt outside the proposed loan.
Here are some of the things that might impact one or more of the variables involved in a debt service coverage ratio calculation.
Vacancy Rate
Just because a property has the potential to generate $50,000 in rental income every year, it doesn't mean that it will. Many rental units have at least some vacancy throughout the year- unless you are one of the lucky ones with a full-time, long-term paying tenant.
The more vacancy a property is prone to, the lower its predicted net operating income is. If this number is low, it leaves less room for debt coverage.
Cash Flow Reliability
Further to the vacancy rate, the reliability of the NOI you put forward also matters. It is important to input figures that hold up since many lenders work a minimum ratio into their contracts
Saying a property generates $200,000 a year when you know an important lease agreement is ending and there are repairs needing to be done can completely alter the result and give you an inaccurate DSC ratio.
When Is Debt Service Coverage Ratio Leveraged in Real Estate?
The most common time to leverage debt service coverage ratios is during the loan application process. Lenders want to know what types of risks they would be exposed to if they grant approval, and this is one of the ways they look.
Usually, a lender looks into a company or individual's finances- specifically the income they have left after operating expenses and how much current debt they have. If an applicant is over-leveraged with debt obligations, a lender may feel less inclined to access the application.
It can also be used to assess a financial situation. In real estate, if a developer sees a project they want to take on but would need a loan to do so, they could check the health of their debt service coverage ratio before moving forward.
If they find they are already uncomfortably close to an outcome of one (having the exact same incoming and outgoing), they might decide to hold off. Alternatively, if they have enough income to pay the debt service on the proposed loan four or five times over, they may go ahead after all!
Another use for a DSCR calculator is to check if you qualify for certain loans. DSCR loans are often offered without the need for W2s or tax returns and can provide up to 80% LTV (loan to value). The condition is a minimum DSCR of 1.2- for the sake of this example.
By using a debt service coverage ratio calculator, you could quickly check whether or not you are able to qualify based on the advised rental income amount and the amount you want to borrow.
Example of a DSCR Calculation
Let's say a real estate company wants to develop a distressed unit to turn it into an upmarket commercial space. They are seeking a loan for the project.
Based on the predicted monthly rent and other earnings, the annual net operating income for the property once the development is finished is $250,000. Based on the lender's calculations, the debt service for the loan will be $75,000.
Assuming they have no other outstanding debts, the calculation would be as follows.
NOI $250,000 ÷ DS $75,000 = DSCR 3.3
With a DSCR of 3.3, this developer should be able to get the loan they need if everything else checks out.
Say, for example, the developer is still paying off the mortgage for the purchase price of the unit and has already taken out a home equity loan for roof repairs.
If the mortgage costs $15,000 per year and the loan payment is $1,000 per month ($12,000 per year), then the total debt service would be $102,000.
The new calculation would look like this.
NOI $250,000 ÷ DS $102,000 = DSCR 2.45
This amount is still generally considered acceptable for most lenders.
What Is a Good Debt Service Coverage Ratio?
Universally, there is no specific debt service coverage ratio that is considered ideal- it all depends on the lender and the specific situation.
As a general rule, the minimum DSCR that can be considered strong is 1.25, meaning the person or company earns at least 25% more than their debts.
A ratio of 1.0 or below is not a good DSCR, as it means you have more debt than income, and your finances could be in trouble if something doesn't change.
It is important to find out if a minimum DSCR is built into your loan agreement before you sign. Some lenders do this to ensure the financial situation doesn't suddenly change after the loan is given, leaving the recipient unable to cover their debt payments.
If your loan contract includes an agreement that you cannot drop below a certain debt service coverage ratio (DSCR), and you do, it could be seen as a default on your loan.
Limitations to Using a DSCR Calculator
There are three possible income measurements to base a DSCR calculation on:
- Net operating income
- EBIT (earnings before interest and tax)
- EBITDA (earnings before interest, tax, depreciation, and amortization)
Each of these is fairly similar, and all create limitations for this calculation. Because these measurements exclude certain expenses, the amount of money a person or firm has available to cover their debts could be overestimated.
Another possible limitation of this calculation is how heavily it relies on accounting guidance, which is not necessarily a true representation of cash needs and timings.
You should also be aware that there is not a regulated number that is considered the minimum DSCR across the board with lenders.
How Can DoorLoop Help?
DoorLoop calculators offer a range of measurements that can assist real estate investors in managing their finances and planning decisions. Having reliable software you can turn to for support in your daily business needs in the rental property market makes a significant difference.
Using DoorLoop to manage your property portfolio streamlines operations, reduces expenses, and maximizes profitability. It also makes your life a little more convenient and organized- leaving more time to focus on taking your company to the next level of success.
There is so much that DoorLoop can do for property managers and real estate investors- but it is easier to show you than tell you! Experience the benefits yourself by scheduling a completely free demo and exploring what DoorLoop has to offer.
Summary
A DSCR loan calculator is primarily used by lenders considering a loan to a property firm or real estate investment company- but it can also be a useful tool for figuring out the financial health of your own business.
It is fairly easy to calculate DSCR- as long as you have a note of all your debt service and income after expenses. Online real estate calculators make it even faster, giving you an instant idea of what potential lenders will be looking at.
DoorLoop helps property manager stay in control of their operations- enhancing productivity and profitability in the process. Don't forget to check out the software and see what difference it could make for you.
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