By Jeff Rauth. Email Here or 248 885-8797. SBA Loan Officer at a Bank That Lends Nationally. 15 Years Commercial Real Estate Experience. Past Commercial Mortgage Broker.
The Debt Service Coverage Ratio (DSCR) is discussed here as it relates to commercial mortgages and SBA loans for both investors and owner occupants (meaning small businesses that occupy the commercial building that they own).
The debt service coverage ratio formula is one of the classic and most important commercial mortgage underwriting ratios used. It gives bankers/underwriters a quick and easy look into the borrowers cash flow thus their ability to “service the debt” ie pay the monthly mortgage payments. The formula is simple, however getting to the net operating income is what is complicated. Here’s the debt service coverage ratio formula:
Debt Service Coverage Ratio = Net Operating Income/Debt Service
The normal minimum DSCR is 1.25 that underwriters want to see in order to approve a loan. On special use properties such as hotels, and or other transactions that seem to have more risk, underwriters normally want to see stronger coverage ratios, like 1.4.
Net operating income, is simply your gross revenue or gross rent minus your expenses (real estate tax, insurance, etc.). Debt service is defined as your mortgage payments (principle and interest) over a period of time, normally a year.
(Want a spreadsheet that you can use yourself to calculate the debt service coverage ratio? We have 2 different versions here.)
Debt Service Coverage Ratio – DSCR – Understanding How It Really Works
For underwriting commercial mortgages, calculating NOI or net operating income is a little more complicated, as underwriters subtract out “holdbacks”. For example, on an investment property, underwriters will take out a vacancy percentage (EVEN IF THE PROPERTY IS 100% OCCUPIED), management fees (EVEN IF YOU MANAGE THE PROPERTY YOURSELF) and factor in replacement reserves (EVEN IF YOU DON’T HAVE THESE SUCH AS WITH ABSOLUTE NNN LEASE).
The percentage used for these holdbacks depends on the individual lender, property type itself, condition of it and the market the property is in. It is a subjective decision the lenders make and one of the major differences between an aggressively lending bank and one that’s conservative. A common vacancy percentage used currently s 6%, though the range is pretty wide from 3% – 15%. A conservative lender will be on the higher side while a more aggressive lender will be on the lower side. If the property is in a distressed area and or a special use property, such as a restaurant, they’ll likely be on the higher side of the range. If the actual vacancy rate with the property itself is higher than market, then they will use that number of sure.
Management fees is another underwriting expense that is taken out even if you manage the property yourself and have no real cost with it. The percentage depends on the turnover of the leases and how they are structured, for example NNN or Gross. The range is normally 2% – 5%. Again this is a subjective decision based on the banks/lenders perception of risk/desire to lend.
“Replacement reserves” is another holdback used to make the loan a little more conservative. It covers general repair costs with the property that you may incur to maintain the property. On multifamily properties they often don’t use a percentage but rather a dollar amount per unit. On non multifamily properties, such as retail or office it is normally 1% -3% of the gross rent.
As you can see, these holdbacks can add up quick and are normally over 10% to 12% of the gross rents. Properties that have low cash flow to begin with, often get declined as these additional underwriting expenses, that a lot of owners don’t think of, send the DCR below the 1.25 standard minimum and put the property in a negative cash flow position; resulting in a declined loan.
Commercial property appraisers will also use all of these holdbacks when that calculate value. So even if you found a lender that will go light on these expenses/holdbacks you may get in trouble with your loan to value, as an income property that is “tight” on cash flow will almost always have issues with loan to value/be over leveraged. They are tied together.
You may also run into the opposite problem with the appraised value. The appraisal report may have more aggressive numbers (lower percentages on the holdbacks) than the bank is willing to use. This always upsets borrowers but when the bank “reviews” appraisals this is what they are doing. We have seen it many times that the funding lender will be more conservative that the appraisal report completed.
On the example below you’ll see a few lines items on LTV that show how much of a dramatic impact these underwriting holdbacks have on value.
Borrowers often get frustrated by these underwriting holdbacks, as they perceive that they don’t exist/incur them. But history has taught banks over and over again that they do exist, and borrowers that ignore them often run into major issues in the future. For example, if the owner does not have enough cash flow to properly maintain the property, they can find themselves in an impossible position as they can’t afford to maintain the property and at the same time their rents decline as the property is not competitive/desirable to tenants, sometime resulting in failed properties/foreclosure.
Global Cash Flow – Global DSCR – Even on Investment Properties
Another holdback that is becoming more and more of an issue is the borrower’s personal expenses. During the boom times, only the property itself would be underwritten (on investment properties). This is no longer the case especially on smaller loans (less then $3,000,000). Now ALL sources of income and expenses are examined. This is often referred to as the borrowers “global cash flow” position. For example, if the borrower’s other sources of income (job, other businesses, or other investment properties) cannot cover the borrower personal expenses, than underwriters will net out the personally expenses out of the NOI on the investment property… This additional expense often kills deals.
Debt Service Ratio, Debt Service – Investment Property – Example
Here’s an example of a refinance. When the owner did their own analysis they came up with a 1.53 DSCR and 64% loan to value. Sounded like a great loan request. When the underwriter did their analysis they came up with a 1.22 DSCR…
It was a 7 unit office building with an unusual modified gross type leases. $2,300,000 loan amount. In short, even though the borrower has kept the property 100% occupied they have not been able to hold the rental rates that they received when they initially bought it 7 years ago. Due to the decline in rents the property can no longer meet the DSCR required in today’s market.
Here’s what the numbers looked like when the borrower calculated them, ie without underwriting holdbacks:
|Total Rents (Gross Income)||$351,772|
|Less Underwriting Vacancy||$0||The owner mistakenly left this blank as the property is 100% occupied.|
|Adjusted Gross Rents||$351,772|
|Taxes||$22,391||Note, the tenants reimbursed the owner for real estate taxes.|
|Water & Sewer||$6,023 |
|Maintenance|| $2,344 |
|Repairs || $5,213 |
|Management||$0||The borrower mistakenly left this out as they "manage the property themselves".|
|Replacement Reserves ||$0||The borrower mistakenly left this out.|
|Phone|| $1,127 |
|Total Operating Expenses||$65,716|
|NET OPERATING INCOME||$286,056||= Adjusted Gross Rents minus Operating Expenses
|DEBT SERVICE ON REQUESTED LOAN||$185,980||5.25%, 20 year term, $2,300,000 loan amount
|NET CASH AFTER DEBT SERVICE|| $100,075 |
|DEBT SERVICE COVERAGE RATIO||1.53||A true 1.53 DSCR should work with any lender. DCR = DS/NOI or $286,056/$185,980 = 1.53
|Property Value based off 8% Capitalization Rate ||$3,576,076||NOI/Cap Rate|
|LOAN TO VALUE||64%||Most banks and lenders won't go over 65% loan to value currently, on investment properties
Here’s how the same deal looks, but in the eyes of an underwriter:
Note, that there’s $58,000 less of NOI to work with… The additional underwriting holdbacks make the deal unfundable with virtually any lender in the country.
Base Rents $329,381 Tenant Reimbursements $22,391 Total Rents (Gross Income) $351,772 Less Underwriting Vacancy At 10% $32,938 Again the vacancy percentage used is a subjective number.
Adjusted Gross Rents $318,833 Expenses Taxes $22,391 Note, the tenants reimbursed the owner for real estate taxes.
Water & Sewer $6,023
Management at 4% $14,070 4% was used as the leases on this were short and "gross" requiring more management.
Replacement Reserves at 3%
$10,553 Property is slightly older & needs maintanance, so 3% was used.
Misc $2,000 Total Operating Expenses $90,340 NET OPERATING INCOME $228,493 = Adjusted Gross Rents minus Operating Expenses. Note that the NOI dropped by $58,000!!!
DEBT SERVICE ON REQUESTED LOAN $185,980 5.25%, 20 year term, $2,300,000 loan amount
NET CASH AFTER DEBT SERVICE $42,512 DEBT SERVICE COVERAGE RATIO 1.22 A Dead Deal with most lenders
Property Value based off 8% Capitalization Rate
$2,856,162 NOI/Cap Rate. The property value dropped in value by $720,000 due to the holdbacks!!
LOAN TO VALUE 80% Dead deal based on loan to value as well. Virtually no lenders in nation will go to 80% on an investment property.
Understanding Debt Service Coverage on Owner Occupied Loan Requests
The formula for calculating the debt service coverage ratio on owner occupied loan requests (your business occupies all or at least 51% the subject property to be deemed owner occupied) is the exact same as on investment properties. Ie net operating income divided by the proposed loan payments (aka debt service).
However, getting to the NOI is often more complicated than on investment properties. For one, the borrowers personal expenses aka “personal needs” are almost always netted out of the businesses cash flow. Calculating personal needs can be complicated as well and differs from one lender to the next. Many banks do this by doubling all of the monthly payments that show up on your personal credit report, than subtract that number out of the businesses cash flow.
Secondly, if there are partners involved, all of their other sources of income and expenses, both personal and business will be calculated. If you have 5 partners, all with various levels of personal expenses and income you can see how quickly this can get complicated.
Thirdly, all affiliates must be underwritten and each individual businesses net income or loss must be factored into the analysis (Again referred to as global cash flow). The percentage of ownership is normally 20%. Ie if you own 20% or more of a business than it will be defined as an affiliate and will have to be underwritten. So if you have your main business that the loan is for, and three other business that you own 25% of, they will all have to be examined, even if they are total unrelated to the loan request…
We have an outstanding spreadsheet for those of you, especially commercial loan officers and brokers that want to calculate global income on owner occ deals. It comes complete with a training manual on how to use it as well. Go here to check it out – Global Cash Flow.
We also have other spreadsheets as well to calculate DSCR and ebook on how to pre screen commercial loan requests and how to broker commercial loans in general. Go here.