Debt Service Coverage Ratio (DSCR) Explained [Real Estate]

The debt service coverage ratio is a very simple formula, but this one metric can have a very big impact on commercial real estate investors.

While it’s pretty easy to look up the definition of this term online, there isn’t much information out there on how the DSCR is actually applied in a real estate context and how this comes into play throughout an entire loan term.

So to add more context around this metric, this post walks through what the debt service coverage ratio is, how this is used within the CRE industry, and exactly when this comes into play for real estate investors.

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What Is the Debt Service Coverage Ratio (DSCR)?

The debt service coverage ratio (or DSCR) measures the number of times over the annual net operating income of a property can cover annual debt service requirements.

This means that this metric can tell both a lender and a borrower how well a property’s operations can support the borrower’s required monthly loan payments, with a higher debt service coverage ratio indicating a lower risk of default, all else being equal.

How Lenders Use The DSCR

Commercial real estate lenders will often use a minimum acceptable DSCR to determine the total loan proceeds they’re willing to issue on a deal, and this is typically referred to as a loan constraint.

DSCR constraints for lenders can vary significantly based on the location of a property, the property type itself, and the overall risk profile of a deal. However, in most cases, commercial real estate lenders will require a debt service coverage ratio of anywhere between roughly 1.25x and 1.5x.

A DSCR that’s within this range makes sure the lender knows that, based on the going-in NOI of a property, the borrower could see their NOI drop materially and still have cash available to service the loan.

How to Calculate Loan Proceeds Using DSCR

Once a lender decides what their minimum acceptable DSCR value will be, they’re then going to use this to back-solve for a loan amount, and this can be calculated directly by using the PV function in Excel.

Excel’s PV function can calculate a loan amount based on an interest rate, an amortization period, and a monthly payment amount, so if we have a property’s projected NOI and the DSCR constraint from the lender, we can use all of this information together to calculate loan proceeds.

An Example

If a lender were evaluating a deal where they planned to charge a 5.5% interest rate with a 30-year amortization period, the going-in annual NOI of the property was projected to be $100,000, and the minimum DSCR they’d be willing to accept was 1.25x, this loan could be sized in Excel by using the PV function with:

• The 5.5% interest rate divided by 12 as our ‘rate’
• The 30-year amortization period expressed as a number of months as our ‘nper’
• The $100,000 NOI divided by 1.25 to calculate the annual maximum loan payment, and then this number divided by 12 as our ‘pmt’

All of this together produces a loan amount of $1,174,145, which would represent the maximum loan proceeds this lender would be willing to issue based on their 1.25x DSCR constraint.

Why DSCR Matters During the Loan Term

The DSCR is important when a lender is sizing a loan, but the DSCR is also really important for both lenders and borrowers to track throughout the entire loan term for a few different reasons.

Watchlists and Increased Monitoring

If the DSCR on a deal falls below a certain threshold, lenders will often put that loan on what’s referred to as their “watchlist”. This essentially means they’ll be looking for extra communication with the borrower to make sure property performance is trending in a positive direction, and if not, the borrower has a plan to turn things around.

In many cases, a loan being added to the watchlist will also come with more stringent reporting requirements, increasing the frequency that borrowers need to provide the lender with things like updated financial statements, updated rent rolls, or leasing activity reports for struggling commercial properties.

Potential Default Triggers

In some cases, a borrower falling below a certain debt service coverage ratio can actually trigger an immediate loan default. And even if this doesn’t result in foreclosure, this can often trigger things like:

• Additional equity funding requirements to add to a reserve account
• Additional fees or penalties charged by the lender
• The lender requesting immediate full repayment of the loan before the loan matures

In most cases, lenders will be willing to work with a borrower to prevent foreclosure if possible, often by either temporarily or permanently modifying loan terms. However, knowing that this type of situation could come into play for an investor, even if they are able to service their debt on a monthly basis, is extremely important to know before going into a deal.

DSCR’s Impact on Refinancing

If the borrower wants to hold onto a property beyond the initial loan term, the DSCR can also play a key role during a refinance.

At the end of the loan term, the borrower will need to replace the existing loan amount with refinance proceeds to avoid having to make an additional equity investment to pay off the outstanding loan, and the DSCR can be a very important metric to make sure they can do that.

The “Debt Funding Gap” Problem

To put this into context, if a property generating $1,000,000 of NOI annually was acquired 5 years ago and financed with a loan that was sized based on a 1.3x DSCR constraint using a 4.25% interest rate and a 30-year amortization period, the loan amount at acquisition would have been a little over $13 million.

But if we fast forward to today, even if we assume the NOI of this property has grown by 3% per year over the last 5 years, if that interest rate was now 6.5%, using that same 30-year amortization period and 1.3x DSCR constraint, the same lender would now only be willing to fund $11.75 million in total loan proceeds.

In this case, even with 5 years of principal payments reducing the outstanding loan balance to just $11.8 million at maturity, our refinance proceeds still couldn’t cover this. And in scenarios where loans are full-term interest-only, or the NOI of the property doesn’t increase significantly during the loan term, this is where investors can start to run into trouble.

How To Learn more

If you want to learn more about how the DSCR, debt yield, and other loan metrics play into a real estate investment analysis (and how to model these in Excel), make sure to check out our all-in-one membership training platform, Break Into CRE Academy.

A membership to the Academy will give you instant access to over 120 hours of video training on real estate financial modeling and analysis, you’ll get access to hundreds of practice Excel interview exam questions, sample acquisition case studies, and you’ll also get access to the Break Into CRE Analyst Certification Exam, which covers topics like real estate pro forma and development modeling, commercial real estate lease modeling, equity waterfall modeling, and many other real estate financial analysis concepts that will help you prove to employers that you have what it takes to tackle the responsibilities of an analyst or associate at a top real estate firm.