What Is A Debt Service Coverage Ratio? How Do I Use It To Mitigate Risk?

August 20, 2021
Categories: All Market Volatility

One of the most important concepts in real estate investing is leverage. Leverage is the ability for someone (or a team of people, such as a sponsor or development group) to finance a substantial part of the property's acquisition and/or redevelopment costs. Unlike stocks, bonds and other equity investments that require someone to pay face value, investors can use leverage to limit their up-front and out-of-pocket expenses. For example, if someone is purchasing a $1 million property, they might be able to finance $750,000 using a traditional bank loan. This leverage limits their out-of-pocket expenses to $250,000 - a much lower barrier to overcome than having to pay $1 million personally.

However, obtaining a loan of this size (or more) can be difficult. Lenders will usually look at both the borrower's personal income and value of their assets, as well as the property's income-generating potential.

When evaluating whether or not to make a loan, lenders will use a metric known as the "debt service coverage ratio" to assess the latter—i.e., the property's income-generating potential. In this article, we look at the importance of DSCR and how investors can use this metric to mitigate their risk.

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What is the Debt Service Coverage Ratio (DSCR)?

The debt service coverage ratio, often referred to as "DSCR," is a metric that both investors and lenders use to determine whether the income generated by a property can sufficiently support its debt obligations.

A property with a DSCR of less than 1.0 is considered to be losing money and would not have enough income to cover debt payments. A property with a DSCR greater than 1.0 is considered to be profitable. From a lender's perspective, the higher the DSCR, the better.

The DSCR ratio is used in conjunction with the loan-to-value (LTV) calculation. Properties with a higher LTV ratio may have a lower DSCR ratio and vice versa. Therefore, in order to meet a lender's preferred DSCR ratio, a borrower may need to put more equity into the deal to lower the LTV. Ultimately, this is one of the primary ways lenders mitigate the risk of borrower default.

Related: Terms and Definitions: Debt Terms

How to Calculate the Debt Service Coverage Ratio

The debt service coverage ratio is as follows:

  • DSCR = Net Operating Income (NOI) / Debt Obligations

In order for this calculation to be accurate, the borrower needs to have a strong grasp on the property's NOI.

The NOI includes all rental income plus other income (e.g., parking fees, storage fees, laundry or vending machine income, billboard/signage fees, etc.). Vacancy losses and all operating expenses (including property taxes, maintenance, and management fees) are then subtracted from that sum to determine the NOI.

  • NOI = Total Income - Total Operating Expenses and Vacancy Losses

Debt obligations are more straightforward. At a minimum, it is the principal and interest payment owed to the lender each month. A lender's DSCR calculation might include property taxes and insurance, as well. If these are included as debt obligations, they should not be factored into the operating expenses when calculating total NOI. They should only be accounted for once, on either side of the DSCR equation.

By way of example, let's say a self-storage facility has an NOI of $3.0 million and annual debt obligations of $2.2 million. In this case, the DSCR would be:

  • $3.0 million / $2.2 million = 1.36x DSCR

Most lenders like to see a DSCR of somewhere between 1.25x and 1.50x, so the example above would represent a relatively healthy DSCR. From a lender's perspective, the higher the DSCR, the better, as this means there is more income available to cover debt obligations.

Related: Terms and Definitions: Income and Expenses

The Importance of DSCR

DSCR is important to any borrower interested in securing a loan to purchase, renovate or refinance a commercial property. This is true regardless of product type (i.e., multifamily, office, hospitality, retail, self-storage and the like). Some lenders may be willing to make a loan based solely on a borrower's income, credit and the value of their assets. Most, however, will also look at the amount of income that will be generated by the property and whether this is sufficient to cover debt obligations.

This is particularly true among asset-based lenders, who almost exclusively rely on DSCR to determine whether a borrower qualifies for a certain loan amount. The more income a property generates relative to its debt service obligations, the greater the likelihood of loan repayment. Most lenders want to see DSCRs of at least 1.25 to 1.50x. This means that the property generates 1.25 to 1.50x the income needed to make debt payments.

With a particularly strong DSCR, a borrower may be able to secure a loan at favorable terms regardless of their personal income or credit history.

Aside from financing implications, DSCR can be a useful tool for those looking to conduct a quick, side-by-side analysis of various investment opportunities. While DSCR is only one metric to consider, it provides a quick, easy-to-understand snapshot of a project's potential profitability.

Using DSCR to Increase Profitability

DSCR can prove to be very insightful for investors. An investor might, for example, look at the in-place NOI and debt obligations and then, assuming the DSCR is low, may use this as an opportunity to identify cost savings. For example, an investor may find that in-place rents are below-market average. If they are able to increase rents by 10 percent, that may increase the DSCR calculation.

Likewise, an owner may find that their operating expenses are higher than average. This could be the incentive an owner needs to revisit vendor contracts or make property improvements that will lead to greater efficiencies.

As you might imagine, a property's DSCR can fluctuate over time. The calculation relies on a snapshot in time; the inputs to that calculation may change from year to year as leases renew, tenants roll over, property improvements are made, etc. Assuming a property's DSCR substantially improves with time, it may be worth refinancing the existing loan into a new loan at a lower rate or better terms since lenders will find the deal more attractive as the DSCR increases.

Collectively, any adjustments an owner makes to improve the DSCR will result in greater profitability for investors, as well.

Related: How Self Storage Is Managing These Turbulent Times

Conclusion

The DSCR is an important metric for any business owner interested in obtaining a loan - real estate related or otherwise. The higher the going-in DSCR and the higher the projected DSCR after property improvements, the less risk associated with debt repayment. Deals that have less risk will inherently qualify for better rates and terms among commercial lenders.

By understanding a property's DSCR, investors can make more informed decisions about property improvements, operations, and financing alternatives - decisions that will ultimately impact a project's total cash flow, and by extension, the returns investors might expect.

If you would like to get started with investing in self-storage, reach out to us and we will help you get started.