What is Debt Service Coverage Ratio
The debt service coverage ratio (DSCR) is a metric used to evaluate how much cash flow is available to make the necessary annual payments on any outstanding debts. The DSCR definition shows the ability (or lack thereof) to pay all the interest and principal of any outstanding debt for a year.
DSCR calculation plays an important role in evaluating investment opportunities. The DSCR ratio tells the relative risk of a company’s default on its debt obligations.
Read on to become an expert in everything you need to know about debt service coverage.
What is Debt Service Coverage Ratio in Real Estate?
Debt service coverage ratio is:
Annual net operating income divided by the total annual debt payments.
The DSCR is 1.0 if a company has an annual net operating income equal to the required annual payments of interest and principal on all debt.
Debt includes a total of all short-term and long-term debt and leases. If the DSCR is above 1.0, that’s better. The higher the number, the stronger its position is with a greater ability to pay its debts.
In real estate, having a higher DSCR for an income-producing property is optimal. This ratio is useful as a comparative tool to analyze similar investments under consideration.
Calculating Debt Service Coverage Ratio
Here are the steps to calculate the debt service coverage ratio:
- Use the most current set of financial reports.
- Get the figures needed to calculate the annual net operating income.
- Add up all the annual debt payments.
Here are the formulas to use:
What is DSCR?
DSCR = NOI/Annual Debt Payments (AKA “Debt Service” or just “Debt Payments”)
Net Operating Income (NOI) = Annual net income + depreciation + interest expenses + amortization and other non-cash items
What is a debt service?
Add up one year’s worth of principal repayment + interest payments + lease payments
Debt Service Coverage Ratio Formula
The debt service coverage ratio equals the annual net operating income divided by the annual debt service.
What is a Good Debt Service Coverage Ratio?
If the calculation of the DSCR results in a ratio of 1.0, this means the company barely has enough net operating income to cover its debt service. This ratio indicates the company is riding on the razor’s edge of being near a loan default.
If a company has a debt service ratio of 1.25, this ratio is much more comfortable. After paying its debt service obligations, the company still has one-quarter of the debt service amount left over. There is little to no risk of default. The company operates with sufficient net operating income to handle its debt service.
What is DSCR in real estate?
When the DSCR real estate calculation shows a ratio of 2.0 or higher, the company is in a stronger financial position and could likely safely take on more debt.
The debt service coverage ratio real estate lenders want to see is 1.25 to 1.50 because, for them, that is a good debt service coverage ratio.
This ratio means the borrower has sufficient debt coverage for paying a loan. If the DSCR is too low, a lender may require an interest reserve. An interest reserve is an account balance held to ensure funds are available to make the loan payments.
What is debt yield?
Debt yield is a way that real estate lenders calculate leverage. The debt yield calculation uses the NOI and divides it by the total loan amount. For example, if the NOI is $100,000 and the loan amount is $1 million, the debt yield is 10%. Usually, 10% is considered the minimum debt yield for a loan, and a higher percentage is more attractive to lenders.
Pride of Ownership
Some income-producing real estate does not make enough operating income to service its debt. Such a property is not considered a positive cash flow investment. These properties might be “pride of ownership” properties, but their owners are essentially taking a loss. If the property is not appreciating substantially to cover the ongoing losses by becoming more valuable, it may not be a worthwhile investment.
Understanding how to evaluate DSCR is important to real estate investors. Knowing how to determine the DSCR ratio on a property can help you figure out what, if any, relative risk there may be on an investment.
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