Debt Service Coverage Ratio – DSCR (Overview)

Hi, this is Trevor and today we’re
talking about Debt Service Coverage Ratio. DSCR is an underwriting term used
by lenders that effectively sets a minimum for the amount of net operating
income available to cover the debt service. The ratio is often set right
around 1.25… Sometimes it’s 1.2, sometimes it is 1.3. It depends on the industry, the
market, the market timing, and the product type. Debt service coverage ratio tells
us how much extra cushion we need to have in our net operating income over
the debt service or the annual loan payments. In this case, a 1.25 debt
service coverage ratio means that the NOI needs to be 125% or 1.25 times the amount of the annual loan payments. Debt service coverage ratio
sets a limit on how much risk the lender is going to take in terms of what they
loan compared to the cash flow on the property. They don’t want to put
borrowers in a position where they have barely enough net income to cover the
debt service, or even worse, not enough net income. So the debt service coverage
ratio builds in the amount of cushion that they want. Lenders can adjust this
for competitive reasons or market reasons, but it typically is about 0.25
over the debt service amount. So let’s take a look at an example. Imagine a property has $100,000 of net operating income. Well, if we look at our
formula, if 1.25 is our minimum ratio, that means that 1.25 equals $100,000
divided by X, and would make X=$80,000. So this makes $80,000 our maximum annual
debt service. So we take that number, we divide it by 12, and we know that our
maximum monthly loan payment is going to be $6667. So understanding this, if the debt service coverage ratio dictates what our
maximum loan payment can be, then one thing that we need to recognize is that
our debt service amount that is allowed by the lender is capped at $6667. If
interest rates go up, the payment cannot go up beyond that. So if interest rates
rise, then the loan amount would have to go down, in order for us to stay
within the minimum required debt service coverage ratio. Let’s look at the
numbers behind that. So if we’ve already determined that our debt service
coverage ratio is a minimum of 1.25 and we have $100,000 in
net income, then we know that X, which in this case would be $80,000 is
our maximum debt service per year, or $6667 per month. Let me show you how this would be calculated in the face of changing interest rates, or perhaps a
shorter amortization period. I’m going to lay this out the way we would lay it out
in a financial calculator. if you haven’t taken that lesson yet just check out our
other videos on financial calculators, calculating debt service, present
value, etc. So let’s imagine we’re punching this into our financial
calculator. In this example, I’m going to use a 30-year fixed loan with monthly
payments at 6% fully amortizing. So here’s what we’ve determined – we’ve
determined that our maximum loan payment each month can only be $6667. If we have a 6% interest rate and we’re doing a 30-year or 360 month amortization, we get
a $1,112,000 maximum potential loan. Typically, if our net operating income is fixed, then our maximum loan payment is also fixed. If interest rates in this case should go
up to 7%, still amortized over 30 years, and knowing that our payment
can’t go up this would bring our maximum loan amount to $1 million.
Similarly, if we still had a 7% interest rate but our amortization was shortened
to, say, 25 years or 300 months, and our payment’s still capped at $6667, then our
loan amount would be reduced even further to $943,000. So debt service
coverage ratio, again, tells us what the percentage of the net operating income
over the debt annual debt service needs to be, and as we can see, annual debt
service can be affected by both interest rates and amortization. Most importantly,
what we need to remember here is debt service coverage ratio lets us know how
much extra net operating income we have over our loan payments. This has been an
overview on debt service coverage ratio. Thanks for watching!


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