Applying for any type of real estate loan can be a lengthy and complicated process. When you are attempting to purchase commercial property, the procedure and requirements can be even more confusing. During the application and underwriting process, you are likely to hear several different terms, including amortization, loan-to-value ratio and more. You may also hear your lender talking about the debt service coverage ratio.
If you are applying for a commercial real estate mortgage, the debt service coverage ratio will make a significant difference in whether you are ultimately approved for your loan. It will also have an impact on your ability to make the loan payments. For this reason, it is important to understand what this ratio is, what it means and how it is used in the underwriting process. Below is some basic information about the debt service coverage ratio to help you understand this concept and apply it to your own commercial financing needs.
What Is the Debt Service Coverage Ratio?
The debt service coverage ratio, which may also be called simply “DSCR,” Is a critical component of the loan underwriting process for commercial real estate. This ratio also plays an important role in determining the maximum loan amount for any specific property.
Specifically, debt service coverage ratio is defined as the net operating income divided by the total debt service. “Net operating income” Refers to the property’s total revenue minus reasonable operating expenses over a certain period. “Debt service” is the amount of money required to cover the principal and interest payments on a property during the same specific period.
The debt service coverage ratio is a common component used in approving commercial loans. Lenders look at this ratio to gauge the borrower’s ability to repay the loan.
Interpreting Debt Service Coverage Ratio
The debt service coverage ratio provides important information about the property’s ability to cover its own debts. If the debt service coverage ratio is less than 1, it means that the property is not generating enough income to completely cover its mortgage debt. If the debt service coverage ratio is equal to 1, it means that the property generates just enough income to cover its mortgage debt. Finally, if the debt service coverage is greater than 1, it means the property generates more than enough income to cover its mortgage expenses.
In general, you want the debt service coverage ratio to be as high as possible. The higher this ratio, the easier it will be for you to make the mortgage payments and still take home a profit. In addition, a higher debt service coverage ratio will make it easier for you to get the loan approval you need and complete the transaction quickly.
Debt Service Coverage Ratio vs LTV
Many mortgage loans use loan-to-value ratio, or LTV, to determine the maximum loan amount a borrower can qualify to receive. Loan-to-value ratio is calculated by comparing the amount of the loan to the value of the property in question. Lenders have different maximum LTV requirements and may even change these requirements based on other compensating factors, such as high credit scores or plenty of borrower income.
Debt service coverage ratio looks at the mortgage in a completely different way than LTV. While the LTV focuses on the property’s intrinsic value, the debt service coverage ratio focuses on the ability of the property to generate income.
In many cases, lenders will have both LTV and debt service coverage requirements that must be met to qualify for mortgage. In such cases, each of these requirements will need to be satisfied. For example, assume a lender requires the LTV to be no more than 85 percent and the debt service coverage ratio to be at least 1.2. If your requested loan amount would have an LTV of 80 percent but the debt service coverage ratio is only 1, the loan amount would need to be lowered until the debt service coverage ratio passed the 1.2 mark.
How Lenders and Underwriters Use Debt Service Coverage Ratio
At first glance, it may seem like you should be able to qualify for your requested loan as long as the debt service coverage ratio is at least 1. However, this is not typically the case. When the debt service coverage ratio is equal to 1, it means that the property is generating just enough income to cover its own mortgage debts. Most lenders prefer more security, so they typically require a minimum debt service coverage ratio higher than 1. For example, the lender may not be willing to approve a mortgage loan unless the debt service coverage ratio is at least 1.2, which would provide a 20 percent cushion in case the property’s income were to change in the future.
Calculating the Debt Service Coverage Ratio
To calculate the debt service coverage ratio for a given property and a specific desired loan amount, begin by finding your property’s net operating income. You can calculate this figure by totaling your property’s gross revenue and subtracting expenses. For example, if the building in question is an apartment complex, your gross income may include the potential rent you would collect. Expenses would include the cost of repairs and maintenance, property insurance expenses, property taxes, pest control and any payroll expenses you may have.
Next, you must calculate the property’s debt service. This figure is calculated by adding the monthly principal and interest payments for the loan amount you are requesting and multiplying by 12. Finally, divide the net operating income by the property’s debt service to obtain the debt service coverage ratio.
The basic definition of debt service coverage ratio makes it seem like the calculations would be simple for the borrower to perform on their own. However, it is important to note that lenders may calculate the debt service coverage ratio differently. Because lenders want to be careful when calculating these figures, they often adjust different numbers used in the calculation, such as the net operating income. For example, many lenders will reduce the net operating income supplied by the borrower by subtracting certain expenses or risks, such as vacancy rates, tenant rollover risks and a certain amount of cash reserves. Nonetheless, you can get a good idea of the value the lender will calculate by estimating the debt service coverage ratio on your own.
What Happens if the Debt Service Coverage Ratio Is Too Low?
In general, the debt service coverage ratio can never be too high. The higher this figure, the more confident the lender will be in your ability to make your loan payments. However, in many cases, the debt service coverage ratio for a specific loan amount may be too low. When the debt service coverage ratio is too low, you have a few options.
1. Make a bigger down payment.
Perhaps the easiest way to increase the debt service coverage ratio is to make a larger down payment on the property. When you make a larger down payment, the debt service will decrease, which in turn increases the debt service coverage ratio. However, not all borrowers will have the funds available to use this strategy. In addition, if you were counting on the property to pay for itself and provide a profit, you may not want to put any more of your own cash reserves toward the purchase.
2. Negotiate a lower price.
If the debt service coverage ratio is too high, you may be able to negotiate a lower price with the seller. Although some sellers may be resistant to the idea of lowering the price when you have already made a higher offer, the seller may be willing to compromise if the deal won’t go through any other way. You may also be able to strengthen your position in the negotiations by showing the seller that the property is not going to generate enough income to cover your loan payments, which indicates that the original price may have been too high.
3. Dispute the lender’s calculations.
In the end, the lender will make the final decision when it comes to calculating debt service coverage ratio and approving a requested loan amount. However, it may be possible to raise the lender’s calculated debt service coverage ratio if you can provide substantial evidence that the calculation is too conservative. For example, if you can show documentation that disputes any of the figures the lender used to calculate the debt service coverage ratio, they may be willing to adjust the calculations.
It is important to note, however, that it is in your best interest as a borrower to have an accurate debt service coverage ratio during the underwriting process. If you take on a loan with a debt service coverage ratio that was calculated inaccurately, you may find it difficult to keep up with your loan payments.
Preventing Problems Related to Debt Service Coverage Ratio
Nothing is more frustrating than making an accepted offer on a property, only to learn that you won’t be able to get the financing you need due to a low debt service coverage ratio. To prevent this problem, start taking the debt service coverage ratio into consideration before you ever make an offer on a piece of commercial property. Although you won’t be able to calculate this figure exactly, you can request enough information from the seller about the property’s ability to generate an income to make a good estimate of the net operating income you can expect. Using this estimate, you will be able to calculate what the debt service coverage ratio would be for different loan amounts.
After you have an idea of the debt service coverage ratio for various loan amounts, you can use this information to decide how much you can reasonably afford to pay for the property. Set an upper limit for your offer and don’t exceed it, even if the seller tries to push the price higher. Remember that it is best to leave yourself an ample cushion so you can be sure you will be able to afford the mortgage payments easily. It is not in your best interest to take on a loan with a high debt service coverage ratio, as you may ultimately lose money if the property’s net operating income drops.
Seek Expert Advice
Understanding the debt service coverage ratio, as well as all the other calculations you should consider when purchasing commercial property, can be challenging. Also, it can be difficult to decide how you should proceed when the debt service coverage ratio is lower than you expected it to be. In cases where you aren’t sure whether to proceed with a loan, it can be helpful to seek advice from an expert, such as an accountant. Your mortgage lender will also be able to provide guidance and answer any questions you may have about these issues.