In the world of commercial real estate finance, few terms are more important than the Debt Service Coverage Ratio (DSCR). In this article, we’ll cover some of the frequently-asked questions about the DSCR and explain how it impacts companies looking to acquire income producing commercial real estate.
What Is the Debt-Service Coverage Ratio?
DSCR measures a property’s cash flow and the ability for the owner to pay their debt obligations.
The ratio compares net operating income to the debt obligations due within one year. The DSCR calculates for all the various factors of debt, including interest, principal, sinking funds, and lease payments.
In other words, the DSCR is a number derived from the net operating income divided by the annual debt service for a given year.
What is a good DSCR?
The DSCR is given as a number out to two decimal places, for instance 1.10. There is no set benchmark, but a DSCR below 1.0 indicates that there’s not enough cash flow to cover existing debt payments.
Even if the DSCR is above 1.0, it can indicate vulnerability. A DSCR only slightly above 1.0 – 1.1 or 1.2, for example – demonstrates that cash flow is perilously low. Even a small decrease in cash flow over the course of a year could leave the company unable to meet debt obligations.
Lenders generally prefer corporations with a DSCR of at least 1.25. This provides roughly a 25% “cushion” in the net operating income, allowing the company to meet its obligations even when its cash flow is unexpectedly reduced.
What is negative cash flow?
When a company’s DSCR falls below one, it indicates negative cash flow. There’s not enough operating income to cover existing debts. With negative cash flow, one of the only ways to meet existing obligations is to rely on external sources or borrow more money to cover the debt.
How is the DSCR calculated?
While the basic formula doesn’t change, every institution calculates the DSCR slightly differently. That includes how institutions factor in one-time payments and investments back into properties. Further complicating matters is the fact that interest is a tax-deductible expense while principal is not.
More importantly, different lenders look for different results from a company’s DSCR. Some sectors, such as hospitality and travel, require larger DSCR cushions. They might require a ratio of 1.50 or greater. In other sectors, a DSCR closer to 1.20 might still be acceptable.
How is the DSCR used?
There is no one figure that designates a company’s cash flow reserved only for debt service. The DSCR comes the closest, providing a base ratio that helps lenders and businesses understand the risk of taking on a new debt obligation. It can prevent companies from overextending themselves, and guide lenders to making intelligent loan decisions.
The DSCR is a general figure, however, and may not represent the complete financial picture for a company. For commercial real estate investments, the DSCR is a good starting point for any analysis, but it often requires context.
Does the DSCR affect loan amounts?
Because the DSCR is a simple ratio, it can be used to project the impact of future loans. Lenders can use the DSCR to calculate the maximum amount they are willing to lend to a particular business. On their side, businesses can use the DSCR to find a loan amount that covers the real estate investments needed without overly burdening the company with unmanageable debt.
For companies managing extensive real estate portfolios or complicated commercial real estate arrangements, the DSCR provides a way to gain a quick snapshot of their debt position. It can’t give all the details, but it can serve as a useful indicator of a company’s current position.