DSCR- Its importance for lenders
The debt service coverage ratio is one of the metrics used to measure debt capacity wherein it measures the company’s ability to repay its loans, take on new financing and make dividend payments. It is a benchmark usually used to comprehend an entity’s ability to generate funds to cover their debt payments. A higher ratio is usually preferred in order to obtain financing.
It is calculated as a ratio of Net Operating Income/ Annual Debt Service.
This ratio is an indicator of how much the cash flow generated by the property will be able to cover the commercial loan payments. Most lenders require a minimum DSCR of 1.2x. DSCR of at least 1.0x are considered a breakeven and anything less than that will be considered a loss for the prospective debt structure taken on by the entity with a few exceptions of heavy value-add, development etc.
Importance for lenders-
For lenders, the DSCR is important in underwriting commercial real estate loans because it provides information concerning a borrower's ability to sustain and pay off debts for a commercial or multifamily property. Therefore, it's important to know because it helps lenders evaluate if their borrowers can successfully generate enough cash flow to cover the loan payments.
However, in some cases, lenders will look beyond the specific DSCR of the property, and instead, will look at something called global DSCR. Global DSCR looks at the property owner's personal income and expenses. This way, a lender can see a borrower has other sources of income that can bolster the project's net operating income in the case of financial distress and that the borrower has the room to absorb the hiccup of the distress and can afford to fulfill the obligation of the loan hence taken. If a property owner does have other income sources, it increases the borrower's global DSCR and can allow them to get a larger loan. Global DSCR is often more important for small business commercial property loans, such as the SBA 504 or SBA 7(a) loan.
DSCR over LTV?
The loan-to-value ratio is the amount of loan compared to the value of the property. The lender calculates this ratio before providing the mortgage. Although, having a high enough LTV may deem the borrower fit for the loan, that is not always the case. Having a suitable LTV doesn’t suffice and lenders still like to look at the borrower’s DSCR. When the DSCR is below the minimum acceptable level, then the loan amount must be reduced to maintain the minimum DSCR.
Let us assume that the LTV is 70%, but the DSCR is 0.95x which is way below the acceptable 1.2x, which implies that the property’s NOI is not sufficient to service the debt at 70% LTV, hence the loan amount will be reduced until the minimum DSCR is met. This is referred to as the loan amount being debt service constrained.