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Basis of the Commercial Loan-Calculating the Debt Service Coverage Ratio

One of the most important factors used to determine the fund-ability for a commercial mortgage request is the Debt Service Coverage Ratio, commonly referred to as the DCR or DSCR.

The DSCR is a ratio used to determine the amount of debt that can be supported by the revenues generated from the commercial property. Very simply it’s the net income generated by the commercial building divided by the new commercial loan payment.

How the DSC relates to Commercial Mortgage Lending 

One of the main reasons commercial loan modification or commercial loan requests are denied is that the property does not support the lenders or special servicers minimum debt coverage requirements.

DSCR = NOI (Net Operating Income) /Total Debt Service

A common misconception made by borrowers when applying for a commercial mortgage loan is that the bank or commercial lender only uses the expenses from the property when calculating the NOI. Commercial lenders use the actual expenses plus additional line items, such as, off-site management, vacancy, replacement reserves, repairs and maintenance, etc. Commercial lenders add these numbers to the expenses should the borrower default.  They must know the entire cost of taking back the property in event of a default.

How to calculate the DSCR

Here’s an example of how a commercial mortgage lender calculates the DSCR. The lender holdbacks are not actual expenses, but they are deducted from the property’s gross income for underwriting purposes. Example assumes a 186 unit property multifamily property.

The NOI has now been calculated and the next step is to determine the loan payment.  Long term debt is usually principal and interest and you can assume interest only payments on bridge or acquisition financing. The Taxes and Insurance numbers are accounted for in the expenses portion of the above example.

To calculate the DSCR, divide the net operating income (NOI) by the commercial mortgage loan payment.

Commercial Loan Purchase Price: $5,000,000 First Mortgage

Interest Rate: 10.0%

Term: interest only

Annual Payments (Debt Service) = $500,000

Now we can calculate the DSCR:

DSCR = Net Operating Income (NOI) = $717,600

Total Debt Service $500,000

DSCR = 1.44

Cash flow generated by the property will cover the new commercial loan payment by 1.44 x. Because most lenders will require a minimum DSCR of 1.20x this loan is eligible for competitive financing.  So, why do I use a rate of 10% to calculate the debt service?  Your not going to find quick close bridge financing that’s less than 10%.  Most opportunistic funds typically are seeking internal rates of return (IRR) of 18-25%.  If you plan on acquiring distressed commercial property at a discount you will need quick close bridge financing and you will not get competitive market rates until you take over the target asset, stabilize it for twelve months and get it into position for a traditional commercial lender refinance.

If a DSCR is 1.0x, this is called breakeven, and a DSCR below 1.0x would signal a net operating loss based on the proposed debt structure.

Most new lenders are starting to use what’s now being called a global DSCR. A global DSCR is a ratio that combines both personal and property income and expenses when calculating the DSCR. This allows for properties with weak cash flow, or a property in a low CAP area, to still qualify for a private equity commercial loan provided the borrower has additional income and assets to add the property’s NOI.

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Types Of Commercial Loan Financing

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