One of the first things any commercial lender or broker talks about is the debt coverage ratio. Sometimes real estate pros don’t realize that they are throwing around numbers and terms that newer investors may not know.
It’s also true that many investors may understand the term but not understand the intricacies or how to manipulate the numbers to make the deal work.
Let’s dive into it.
Debt coverage ratio definition
The debt coverage ratio (also known as the debt service coverage ratio, DCR, or DSCR) is a simple ratio that tells a lender how much of your cash flow is eaten up by the mortgage payment.
Debt service coverage ratio calculation
In general, it’s calculated as:
Net Operating Income = Gross Income – Total Operating Costs
Debt Service = Principal + Interest
To calculate the debt coverage ratio of a property, first, you need to calculate the NOI. To do this, take the total income, subtract any vacancy, and also deduct all operating costs.
Remember, operating costs do not include debt service (principal and interest), or capital expenditures. Insurance and taxes are operating costs, so don’t forget to include them.
Next, take the Net Operating Income and divide it by the annual debt service, which is the sum of all principal and interest payments during the year.
To do this you must take the entity’s total income and deduct any vacancy amounts and all operating expenses. Then take the net operating income and divide it by the property’s annual debt service, which is the total amount of all interest and principal paid on all of the property’s loans throughout the year.
Why the DCR is important
It’s regularly used by banks and loan officers to determine if a loan should be made and what the maximum loan should be. It’s very common for lenders to require a 1.2 DSCR (1.15 – 1.35 is the most common range).
A Debt Coverage Ratio below 1 means the property does not generate enough revenue to cover the debt service while a DCR over 1 means the property should, in theory, generate enough revenue to pay all debts. The requirement for a 1.2 allows for economic downturns, vacancy, etc to give a buffer for the owner and bank.
Coverage ratio example
Let’s say there is a property that generates $10,000 in revenue, has total operating costs of $4,800, and yearly debt service of $4,000
NOI = $10,000 – $4,800 = $5,200
In this example, the debt coverage ratio is above 1.2, so this would be a good risk for the bank and they’d likely give the loan.
Let’s say that interest rates change and the bank gives a slightly higher rate, causing a new debt service of $4,500.
Notice how a small change can suddenly change everything!
DSCR Example continued
In this situation, the bank generally won’t simply reject the loan. Instead, they will reduce the loan balance until the payment comes in line with their minimum DSCR requirements.
In this situation, the lender will simply reverse the formula and determine what the maximum debt service can be.
1.2 = $5,200 / Max Debt Service
Max Debt Service = $5,200 / 1.2 = $4,333
So, the lender would just reduce the loan balance until the yearly debt service was $4,333 or less. You’ll have to come up with a bigger down payment to cover the difference.
How the coverage ratio can affect your returns
In the example above I showed how a loan can be adjusted down before the lender will give the loan. This can significantly reduce your cash on cash returns.
Let’s say you are buying a property in the example above costs $100,000 and requires a down payment of $25,000 It generates $10,000 in cash each year and has an NOI of $5,200. Originally the debt service was supposed to be $4,000 per year, leaving $1,200 in total cash flow.
Cash on Cash Return = Total Cash Flow / Total Cash Invested
CoC = $1,200 / $25,000 = 4.8%
But due to some fluke, the terms changed and now the debt service will increase. Let’s say that the terms are now a $75,000 loan at 4.5% interest is roughly $4,560/year in debt service, well below the 1.2 minimum.
Punching it into a calculator, the maximum loan value is now $71,000. to create a yearly debt service of $4,320.
This requires an extra $4,000 investment and also will provide less cash flow.
Cash Flow = $5,200 – $4,320 = 880.
If they gave the loan with the old down payment of $25,000:
CoC = $880 / $25,000 = 3.5%
Not very good, right? But, your down payment is no longer $25k, it became $29k.
CoC = $880 / $29,000 = 3.03%