What is DSCR?
DSCR, or debt service coverage ratio, is a metric used by lenders to determine the risk of providing a loan on an income-generating property.
Debt Service Coverage Ratio in Relation to HUD 232 Loans
DSCR, or debt service coverage ratio, is a metric used by lenders to determine the risk of providing a loan on an income-generating property. DSCR is determined by taking the net operating income (NOI) and dividing it by the property’s debt service (interest, principal, lease payments, etc.). HUD 232 and 232/223(f) loans require a minimum DSCR of 1.45x.
To learn more about HUD 232 loans, fill out the form below to speak to a HUD/FHA loan expert.
Get A Free HUD/FHA Multifamily Loan Quote!
What is the definition of Debt Service Coverage Ratio (DSCR)?
Debt Service Coverage Ratio (DSCR) is a measurement of an entity’s cash flow vs. its debt obligations. In multifamily and commercial real estate, that entity is typically an income-producing property, while in corporate finance, the entity is usually a business or corporation. DSCR is defined as the cash flow necessary to pay debts - interest, principal, lease payments, etc. It is used by lenders to determine loans on income properties. The ratio is a formula that divides the net operating income of a business by the total debt service amount:
DSCR = Net Operating Income / Total Debt Service
So, a business with a DSCR of less than 1 does not have sufficient funds to pay back debt obligations, while a business with a DSCR of greater than 1 does.
How is Debt Service Coverage Ratio (DSCR) calculated?
The formula for calculating debt service coverage ratio is fairly straightforward, given below:
DSCR = Net Operating Income ÷ Debt Obligations
While it may be a simple calculation, an investor will need to make sure they are using the correct figures for a property to get an accurate result.
Net operating income or NOI, for example, is typically calculated using earnings before interest, taxes, depreciation, and amortization (EBITDA) for DSCR calculations. This means that taxes, interest, and other costs from the NOI calculation should not be deducted before entering it into the DSCR formula.
The following example shows how the DSCR formula is used in practice:
A multifamily property has an NOI of $3.4 million and annual debt obligations of $2.3 million. In that case, it would have a DSCR of 1.48x, as seen below.
$3.4 million ÷ $2.3 million = 1.48x DSCR
Most lenders would consider this a good DSCR for most multifamily and many commercial real estate finance transactions.
What is the importance of Debt Service Coverage Ratio (DSCR) in commercial real estate financing?
Debt Service Coverage Ratio (DSCR) is an important metric for lenders when evaluating a potential commercial real estate transaction. It is a predictor of a borrower's ability to pay back a loan on time and is used to calculate cash flow analysis for a prospective loan. DSCR is also important for lenders in underwriting commercial real estate loans because it provides valuable information concerning a borrower's ability to sustain and pay off debts for a commercial or multifamily property. The ratio itself compares the target property's net operating income to the target mortgage debt service on an annual basis.
For borrowers, DSCR is important in qualifying for a commercial real estate loan. Lenders will examine the DSCR of any loan they extend to determine if a property generates enough net income to cover its debt obligations. DSCR requirements vary by asset type, but the higher the better. Don’t expect to find many institutions willing to offer you a competitive loan at a DSCR of less than 1.25x.
What are the benefits of having a high Debt Service Coverage Ratio (DSCR)?
Having a high Debt Service Coverage Ratio (DSCR) is beneficial for a number of reasons. A high DSCR indicates that the borrower has sufficient income to cover their debt obligations, which is a sign of financial stability. This can be attractive to lenders, as it shows that the borrower is likely to be able to make payments on time and in full. Additionally, a high DSCR can help a borrower qualify for more favorable loan terms, such as lower interest rates and longer repayment periods.
What are the risks of having a low Debt Service Coverage Ratio (DSCR)?
Having a low Debt Service Coverage Ratio (DSCR) can be a sign of financial hardship and can be a red flag to lenders. A DSCR of less than 1.00 reflects a negative cash flow, which, to lenders means that the borrower will be unable to cover the costs of their debt obligations without needing to borrow more. In practice, a DSCR of 0.93 equates to the borrower only having sufficient income to cover 93% of their annual debt obligations. To a lender, this represents extremely high risk, as this metric basically shows that the borrower will need additional income to be able to make payments towards their debts. Even then, if the debt-service coverage ratio is higher than, but still too close to 1.0, then the borrower is considered to be vulnerable, as any minor decline in cash flow could render them unable to service their debt. For these reasons, the majority of lenders in many cases require that the borrower maintain a minimum DSCR to qualify, and sometimes even a DSCR threshold while the loan is outstanding. In these cases, a lender will consider a borrower who falls below that minimum to be in default. Source 1, Source 2, Source 3.