Debt Service Coverage Ratio (Debt Covrage Ratio /DSCR/DCR) is a popular benchmark for many industries including commercial real estate. In commercial real estate, the definition of DCR is the Net Operating Income (NOI) divided by the Annual Debt Service. DCR is used in financial analysis to determine the appropriate amount of financing for an investment opportunity.
Before you continue reading this article, please note that market conditions vary and you should always consult local mortgage brokers/lenders about financing conditions in your area. Please note that much of the following examples have been simplified.
The Equations
- NOI = Scheduled Gross Income-Vacancy & Concessions – Operating Expenses
- DCR = NOI / Annual Debt Service
- Debt Service = Total Annual Debt Payments
Let’s take an example:
A businessman owns an income producing property that generates a Scheduled Gross Income (SGI) of $300,000 annually from his tenants. In simpler terminology, he earns $300,00 a year from his tenants. His total expenses including taxes, utilities, and maintenance on the property and utilities total $100,000. The local market has a market vacancy reserve of 10%.
NOI = $300,000 – $30,000 – $100,000 = $170,000
The Debt Service can be calculated from the amortized loan.
In a very simple example:
Say our businessman is interested in the property because his trusted broker emailed it to him. From his financial analysis, he knows that the NOI will yield $170,000 annually. The Debt Service required for the loan is $150,000 per year. His DCR would be 1.13 repeating.
DCR = 170,000 / 150,000 = 1.13 repeating.
What does the ratio even mean?
A DCR above 1 means that the investor will receive earnings from the property. A DCR below 1 means that the investor will be paying each year to keep the property. Any investor would want the DCR to be well over 1.
Let’s look at the example again with some more realistic data. Please note that this example is more detailed but still simplified. Our businessman is interested in purchasing the retail plaza. He sees that its NOI yields $250,000. At an 8% cap rate, the building is selling for $3,125,000. He proceeds to the bank, and the bank tells him that he is approved for a 60% loan ($1,875,000) with 6% interest due in 10 years. The $1,875,000 breaks down to $187,500 each year, but with interest, his annual payment is: $249,796.08.
If he chooses to pay off the debt in the allotted time, he will gain $203.92 each year from the NOI.
The DCR is roughly 1, which means that the investor would receive a negligible amount of earnings over the ten years and also have to pay $1,250,000 upfront.
Our businessman, however, chooses to refinance. Without going into too much detail about refinancing (a future topic), our businessman instead chooses to amortize his loan over 20 years and receives another loan to pay off his original loan. In this example, he receives the perfect loan that would cover the remaining 10 years.
Each year, he would pay $161,196.96. Each year, he would then earn $88,804.04, and his DCR would be around 1.55.
DCR = 250,000 / 161,196.96 = 1.55
In the standard 30 year amortization, the businessman would only pay $134,898.84 each year. His DCR would be about 1.85.
His total payment with 30 years is $4,046,966.04.
His total payment with 20 years is $3,223,939.76.
His total payment with 10 years $2,497,961.29.
With longer amortizations, the businessman pays less each year but pays more overall. Please note that all these examples are pretax.
In truth, perfect scenarios in which other lenders give the exact amount needed to finish the previous loan are few and far between. Be wary about how much you can pay off, and how much that will affect you.
There are many variables that could completely throw off these examples including the original loan only being 3 years instead of 10.
This is a topic that I’ll come back to soon.
