If you are new to commercial real estate financing, you
will undoubtedly find that there are a number of important
terms and ratios that one should understand when evaluating
a property. One of these terms is "debt service coverage
ratio," otherwise known as DSCR. DSCR is commonly used by
commercial lenders as the benchmark to determine whether a
property's cash flow will support the loan request that the
lender is considering for financing.
How to Calculate Debt Service Coverage Ratio
The debt service coverage ratio is calculated as follows:
DSCR = Net Operating Income / Annual Debt Service
What Does the DSCR Mean?
Let's say that your DSCR is 1. This means that your
property's cash flow is just enough to make your annual
mortgage payments. If it is less than 1, that means your
property is not generating enough cash flow to support the
debt payments on the property. In such a case, this
negative cash flow would require the owner of the property
to reach into his/her own pockets to cover the difference.
If the DSCR is greater than 1, then your property's cash
flow should be sufficient to cover the annual debt service.
How Do Lenders Evaluate DSCR?
Put simply, the higher the debt service coverage ratio, the
lower the risk to the lender. Most commercial lenders in
the industry are comfortable with underwriting loans with a
DSCR of 1.2. A DSCR of 1.2 means that your property's cash
flow is generating at least 1.2 times the annual debt
service on your property. Converting this to dollars means
that for every dollar that you are spending towards your
debt payments, you are bringing in $1.20. To the lender,
this means you have more than enough net cash to support
your mortgage payments.
Why is it Important to Understand DSCR?
It's important to understand DSCR because what you think is
your DSCR might not be what the lender thinks it should be.
Let's say, for example, that you submit your loan
application to a commercial lender who requires a DSCR of
1.2. You believe your property meets that requirement.
But in the lender's review of the property's historical
operating statements, they find that there are several
revenue items that are not common occurrences, or several
items of expenses that should have been included in your
operating expenses. What lenders often do is "normalize"
the expenses and income. When this happens, their
calculation of DSCR may be much lower than you had
anticipated, thus making your property ineligible for
financing by that lending institution.
Make Sure You Know Your Property's DSCR
Because the DSCR is such a critical factor in a lender's
decision to approve a loan, as a commercial real estate
investor, you may want to seek the assistance of a
qualified commercial mortgage or finance broker who can
help you pre-underwrite your loan scenario BEFORE
submitting the application to any lender. The
pre-underwriting analysis will not only help you prepare
and address any obstacles that may come in your path, but
the analysis will also demonstrate to the lender that you
are serious about your application and that you have done
your due diligence. There is so much capital available for
commercial real estate investors. Just be sure to do your
homework and the financing will follow!
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Contributed by VEC Financial Group.
The VEC Financial Group (VEC) is dedicated to providing
commercial mortgage and business financing to property
owners and entrepreneurs across the country. VEC Financial
provides these services by connecting the right broker with
the right borrower, who ultimately finances with the right
lender.
http://www.vecfinancial.com
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