Debt service coverage ratio explained

Time for some more boring real estate math. I guess this is the blogging equivalent of eating your broccoli. I’ll make it quick and painless, I hope…

What is a debt service coverage ratio (DCSR)?

It is the result of dividing the annual net operating income of a building by the total annual debt service payments called for by a loan.

Banks use the DCSR as a test to determine how much money they can safely loan on a building.

Right now, the rule of thumb for apartment buildings of 5+ units is a DCSR of 1.25 or higher. That means that banks want you to have $1.25 in profit for each $1 in mortgage payment that you will be making. If the ratio is less than 1.25, then the banks will probably reduce the size of the loan they will offer you until the ratio hits 1.25.

Confused? Want more explanation? Let’s pick this concept apart:

  • “Net operating income” is a measure of the profitability of a building. You take the total annual rent and subtract all the expenses, including property taxes but not including any mortgage payments. This is the money that is available to pay a mortgage.
  • “Debt service payments” are what you pay the bank for a loan. You take the monthly payments over the course of a year and add them up to get the annual number.

When you divide the annual net operating income by the annual debt service, you get the DSCR. This number should be around 1.  If it’s less than 1, then there’s not enough income to support the proposed loan.

If DCSR is greater than 1, the building can probably support the loan. The higher the number, the safer the loan (because the more margin there is in case something goes wrong with the building and the profit decreases).

When you’re buying 2-4 unit buildings, the DCSR is not that important, because the lenders spend more time looking at you, the borrower, than they do looking at the property. But as you move up into 5+ unit buildings, and especially when you get into non-recourse loans, the bank is mostly interested in the asset, not you. DCSR is one of the key tests they use to determine whether to make a loan, and how much to loan.

[P.S. I’m meeting with a banker today to discuss a really large re-financing, so this post is particularly apropos. Wish me luck!]