Why I Love the Debt Service Coverage Ratio

You are walking through the doors of the bank, hopeful to get your first commercial loan on a medium multifamily property. You’ve never done this type of investing before, but you do have a few single family homes you are renting out and manage yourself. How tough could an 8-plex really be? It’s the same thing as 8 homes, just all squished together. Getting a loan should be a breeze.

The banker asks you, “What is the DSCR?”

“DSCR?” you ask, worried about what you have forgotten to learn. Have you gotten in over your head?

“Yeah, the Debt Service Coverage Ratio.”

“Umm, It’s OK, I think. Let me show you these papers,” you state as you try to pivot away from the question, shoving a bunch of loose printed spreadsheets in his face.

That wasn’t a great presentation, was it? At best, the banker will figure out the DSCR with the figures you have. At worst, you look like a novice and you might not be great to trust with hundreds of thousands of dollars of loan money. Better learn about the DSCR before you walk in those doors.

The Debt Service Coverage Ratio

The Debt Service Coverage Ratio (DSCR). Oof, that’s a mouthful. We know it’s a ratio, so it’s something divided by something else. It is one of the metrics the bank uses to determine how likely it is that you will pay them back, specifically, if things don’t go according to plan.

You’ve likely already calculated how much income you will be making along with expenses. These came from the seller’s pro forma and maybe through your due diligence. You are confident of these numbers, but you can never be certain. More likely, you will have a good estimate of the NOI.

You hopefully have talked with your banker recently and know about what interest rate you will be getting as well as the LTV (Loan-to-Value, a percentage, which tells you how much down payment you need). Armed with this information, you can make an accurate estimation of the annual Debt Service (the amount of money you pay back to the bank for your mortgage). Whatever money your new company has left over after this is your cash flow, and is a cushion for the bad times. The lower the cash flow, the less cushion you have if a big expense comes up, like a roof replacement, or larger than predicted vacancy due to a pandemic.

Larger mortgages require larger monthly payments. Larger monthly payments need to have a bigger cushion. The bank wants to know that you will have enough money to be paying back your mortgage even when the vacancy goes up. It can never know this for certain, but the more NOI you have, the easier it will be for you to continue writing those checks. But as the value goes up, NOI must go up, too. To compare, we calculate a ratio.

The DSCR is the multiple debt service is to the NOI. It should always be greater than 1 because your NOI needs to be more than your Debt Service, or you will not be able to pay back your monthly mortgage payment. Because it is a ratio is doesn’t matter if you are talking about monthly or annually, or quarterly, or whatever. However, generally, you look at the annual NOI and the annual debt service to make this calculation.

DSCR = Net Operating Income / Debt Service

If the DSCR = 1, then this means that all your NOI is going into paying back the loan. You might think this is good, and it is good to be able to pay back the loan, but if your actual NOI realized is even $1 less than you predicted, you won’t be able to cover the payments to your loan (Debt Service Coverage). Banks want you to be able to pay the debt service and have some left over for other unforeseen expenses, or to save for them. Any profit that goes to you is a nice byproduct. How many times greater is your NOI than your Debt Service? That’s the DSCR.

Banks are different, but a DSCR of 1.2 is a good number. A bank might require it to be higher if you are an unproven investor, or lower if the bank is really hungry to make a loan. DSCR of 1.2 means that your NOI is 1.2x the Debt Service; or, you will have 20% of the NOI remaining after you pay your debt service.

Calculate your DSCR and have it handy next time you talk to your banker about a deal. They will appreciate that you know these terms and at the very least, it’ll make you look more sophisticated. If your DSCR is too low, you might not want to make an offer on the deal, or might want to change your offer. Although, you will probably have decided it is a bad deal before calculating the DSCR. You can probably tell that a low DSCR would accompany a low cash-on-cash return. I’ll let you think about that. See you at the bank!

Dr. Equity