Debt-Service Coverage Ratio (DSCR) Definition

IN THIS GUIDE

What is the DSCR?

The debt-service coverage ratio is a metric that shows lenders if a borrower generates enough income to cover their annual debt obligations.

How is it useful?

The ratio answers vital questions for lenders such as:

  • Does this property generate enough cash flow to cover its debt obligations from operations?
  • Can the property afford this loan?
  • How much risk does this deal hold?

How do lenders calculate the DSCR?

The net operating income (NOI) is the difference between revenue and operating expenses. Revenue doesn’t simply encompass rental income. Other real estate revenue sources are parking fees, service charges, vending machines, and laundry machines. Operating expenses include all indispensable expenses. Operating expenses can be property management fees, insurance, utilities, property taxes, repairs, and maintenance.

Example

DSCR = 1.64x
DSCR = $7,250,000 / $4,400,000

Net Operating Income = $7,250,000
Revenue = $8,500,000
Operating Expenses = $1,250,000

Total Debt Service = $4,400,000
Construction Loan = $1,800,000
Warehouse Acquisition = $2,600,000

What does a 1.64x DSCR mean?

The borrower’s annual income can cover their annual debt obligations 1.64x. This shows a lender that the borrower is more than capable of affording this loan.

Why is this ratio important?

The Global Financial Crisis of 2008 was caused by real estate lenders inability to qualify borrowers correctly. Lenders continuously approved loans to borrowers who were incapable of meeting their debt obligations. An accurate analysis of the DSCR would have prevented millions of household financial catastrophes.

What is the Minimum DSCR?

Today lenders follow rigorous guidelines and require a minimum DSCR of 1.20x. This metric helps lenders size a suitable loan amount for the investor. The minimum DSCR is contingent on macroeconomic conditions. When the economy is in a recessionary state, then lenders will be significantly more conservative and increase the minimum DSCR. When the economy is in an expansionary state, then lenders will be willing to increase their risk tolerance and decrease the minimum DSCR

What is the optimal DSCR ratio?

Borrowers should strive for a DSCR greater than 1.20 as this is the minimum DSCR any lender should accept. A DSCR ratio of 1.20 means that the borrower is capable of paying his annual debt obligations 1.2x based on their annual net operating income. Anything less than 1.20 is considered risky as it doesn’t leave much room for error. Therefore, borrowers should strive for a DSCR above 1.20 to allow room for error, decrease the lenders’ risk, and to reduce their own risk of default and bankruptcy. If the DSCR is less than 1 then this should tell the borrower that they can’t afford the loan based on their current annual income.

Low DSCR vs High DSCR

A low DSCR increases the lender’s risk, increases the borrower’s interest rate, limits the borrower’s loan amount, and signals low-income margins. A high DSCR decreases the lender’s risk, decreases the borrower’s interest rate, increases the borrower’s loan amount, and signals high-income margins.
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