How to Calculate The Debt Service Coverage Ratio (DSCR)

FEBRUARY 17, 2016 BY ROBERT SCHMIDT 6 COMMENTS

The Debt Service Coverage Ratio, usually abbreviated as DSCR or just DCR,
is an important concept in real estate finance and commercial lending. Its
critical when underwriting commercial real estate and business loans, as
well as tenant financials, and is a key part of determining the maximum loan
amount. In this article well take a deep dive into the debt service coverage
ratio and walk through several examples along the way.

Debt Service Coverage Ratio Definition

First of all, what exactly is the debt service coverage ratio? The debt service
coverage ratio (DSCR) is defined as net operating income divided by total
debt service.

DSCR formula definition

For example, suppose Net Operating Income (NOI) is $120,000 per year and
total debt service is $100,000 per year. In this case the debt service
coverage ratio (DSCR) would simply be $120,000 / $100,000, which equals
1.20. Its also common to see an x after the ratio. In this example it could
be shown as 1.20x, which indicates that NOI covers debt service 1.2
times.

What The DSCR Means

What does the debt service coverage ratio mean? A DSCR greater than 1.0
means there is sufficient cash flow to cover debt service. A DSCR below 1.0
indicates there is not enough cash flow to cover debt service. However, just
because a DSCR of 1.0 is sufficient to cover debt service does not mean its
all thats required.

Typically a lender will require a debt service coverage ratio higher than 1.0x
in order to provide a cushion in case something goes wrong. For example, if
a 1.20x debt service coverage ratio was required, then this would create
enough of a cushion so that NOI could decline by 16.7% and it would still be
able to fully cover all debt service obligations.
What is the minimum or appropriate debt service coverage ratio?
Unfortunately there is no one size fits all answer and the required DSCR will
vary by bank, loan type, and by property type. However, typical DSCR
requirements usually range from 1.20x-1.40x. In general, stronger,
stabilized properties will fall on the lower end of this range, while riskier
properties with shorter term leases or less credit worthy tenants will fall on
the higher end of this range.

DSCR Commercial Real Estate Example

The DSCR is critical when sizing a commercial real estate loan. Lets take a
look at how the debt service coverage ratio is calculated for a commercial
property. Suppose we have the following Proforma:

DSCR Proforma

As you can see, our first years NOI is $778,200 and total debt service is
$633,558. This results in a year 1 debt service coverage ratio of 1.23x
($778,200/$633,558). And this is what the debt service coverage ratio
calculation looks like for all years in the holding period:
As shown above the DSCR is 1.23x in year 1 and then steadily improves
over the holding period to 1.28x in year 5. This is a simple calculation, and it
quickly provides insight into how loan payments compare to cash flow for a
property. However, sometimes this calculation can get more complex,
especially when a lender makes adjustments to NOI, which is a common
practice.

Adjustments to NOI When Calculating DSCR

The above example was fairly straightforward. But what happens with there
are significant lender adjustments to Net Operating Income? For example,
what if the lender decides to include reserves for replacement in the NOI
calculation as well as a provision for a management fee? Since the lender is
concerned with the ability of cash flow to cover debt service, these are two
common adjustments banks will make to NOI.

Reserves are essentially savings for future capital expenditures. These

capital expenditures are major repairs or replacements required to maintain
the property over the long-term and will impact the ability of a borrower to
service debt. Similarly, in the event of foreclosure, a professional
management team will need to be paid out of the projects NOI in order to
continue operating the property. While an owner managed property might
provide some savings to the owner, the lender will likely not consider these
savings in the DSCR calculation.

Other expenses a lender will typically deduct from the NOI calculation
include tenant improvement and leasing commissions, which are required to
attract tenants and achieve full or market based occupancy.

Consider the following proforma, which is the original proforma we started

with above, except with an adjusted NOI to account for all relevant expenses
that could impact the propertys ability to service debt:
As you can see in the proforma above, we included reserves for replacement
in the NOI calculation as well as a management fee. This reduced our year 1
NOI from $778,200 down to $728,660. What did this do to our year 1 DSCR?
Now the debt service coverage ratio is $728,660 / $633,558, or 1.15x. This
is much lower than what we calculated above and could reduce the
maximum supportable loan amount or potentially kill the loan altogether.
Heres what the new DSCR looks like for all years in the holding period:

Now when the debt service coverage ratio is calculated it shows a much
different picture. As you can see, its important to take all of the propertys
required expenses into account when calculating the DSCR, and this is also
how banks will likely underwrite a commercial real estate loan.

How to Calculate The DSCR for a Business

The debt service coverage ratio is also helpful when analyzing business
financial statements. This could come in handy when analyzing tenant
financials, when securing a business loan, or when seeking financing for
owner occupied commercial real estate.
How does the DSCR work for a business? The general concept of taking cash
flow and dividing by debt service is the same. However, instead of looking at
NOI for a commercial property, we need to substitute in some other
measure of cash flow from the business available to pay debt obligations.
But which definition of cash flow should be used? Given the importance of
debt service coverage, there is surprisingly no universal definition used
among banks and sometimes there is even disagreement within the same
bank. This is why its important to clarify how cash flow will be calculated.

With that said, typically Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA) or some form of adjusted EBITDA will be used.
Common adjustments include adding back an appropriate capital
expenditure amount required to replace fixed assets (which would offset the
depreciation add back), and also taking into account working capital
changes (to cover investments in receivables and inventory).

Lets take an example of how to calculate the debt service coverage ratio for
a business.

As shown above, EBITDA (cash flow) is $825,000 and total debt service is
$800,000, which results in a debt service coverage ratio of 1.03x. This is
found by dividing EBITDA of $825,000 by total debt service of $800,000.
This gives us an indication of the companys ability to pay its debt
obligations.

If this analysis were for a tenant, we might want to subtract out existing
lease payments and add in the new proposed lease payments. Or, if this
were for an owner occupied commercial real estate loan, we would probably
subtract out the existing lease payments and add in the proposed debt
service on the new owner occupied real estate loan.

Based on the above 1.03x DSCR, it appears that this company can barely
cover its debt service obligations with current cash flow. There could be
other ways of calculating cash flow or other items to take into account, but
strictly based on the above analysis its not likely this loan would be
approved. However, sometimes looking at just the business alone doesnt
tell the whole story about cash flow and debt service coverage.

Global Debt Service Coverage (The Global DSCR)

Calculating the debt service coverage ratio like we did above doesnt always
tell the whole story. For example, this could be the case when the owner of a
small business takes most of the profit out with an above market salary. In
this case looking at both the business and the owner together will paint a
more accurate picture of cash flow and also the debt service coverage ratio.
Suppose this was the case with the company above. This is what a global
cash flow analysis might look like if the owner was taking most of the
business income as salary:

In the above analysis we included the business owners personal income

and personal debt service. Assuming the owner was taking an abnormally
high salary from the business, this would explain the low debt service
coverage ratio when looking at the business alone as in the previous
example. In this new global debt service coverage calculation we take this
salary into account as cash flow, as well as all personal debt service and
living expenses. Digging into how personal cash flow is calculated is beyond
the scope of this article, but most of this information can be found just from
personal tax returns, the personal financial statement, and the credit report,
all of which will be required by a lender when underwriting a loan.

As you can see, this new global DSCR paints a much different picture. Now
global income is $1,575,000 and global debt service is $1,100,000, which
results in a global DSCR of 1.43x. This is found by simply dividing global
income by global debt service ($1,575,000/$1,100,000). More often than
not, a global cash flow analysis like this tells the full story for many small
businesses.

Conclusion

In this article we discussed the debt service coverage ratio, often

abbreviated as just DSCR. The debt service coverage ratio is a critical
concept to understand when it comes to underwriting commercial real
estate and business loans, analyzing tenant financials, and when seeking
financing for owner occupied commercial real estate. We covered the
definition of the debt service coverage ratio, what it means, and we also
covered several commercial real estate and business examples for
calculating the debt service coverage ratio. While the DSCR is a simple
calculation its often misunderstood and it can be adjusted or modified in
various ways. This article walked through the debt service coverage ratio
step by step to clarify these calculations.