Understanding Debt-Service Coverage Ratio
During the process of deciding whether to approve a request for a commercial real estate loan, lenders use specific ratios to calculate the health of a business. One of the main ratios is known as debt-service coverage (DSCR). Understanding how it is calculated and why it affects the likelihood of having your loan request approved can help you to navigate the lending process with greater ease.
How to Calculate the Ratio
The DSCR measures how much cash flow is available to cover mortgage payments. It is calculated by dividing annual net operating income by annual debt obligations such as principal and interest. If the ratio is greater than 1, this indicates that the business has enough income to cover its debt. A ratio of less than 1 indicates that it does not have sufficient income to do so. Commercial lenders vary in their minimum DSCR requirements, but most prefer to see a ratio of 1.25 or higher.
As an example, a business operating with $200,000 annually and a debt of $140,000 has a DSCR of 1.43, indicating that it has 43% more revenue than needed to ensure that expenses are covered. A business that operates with $200,000 annually and a debt of $220,000 has a DSCR of .91, which signifies that it is has a negative cash flow and can only cover 91% of its annual debt obligations.
Why Lenders Use Debt-Service Coverage Ratio
When deciding whether to approve a loan, lenders determine whether the borrower will be able to pay back the amount that is owed. The DSCR is one measure of how well a business is doing and therefore the likelihood that it will continue to produce enough income to cover the loan and interest. In order to see that you operate a thriving business, lenders also will want to see DSCR for previous years. They also will want to see your projected ratio for the next three years.
How the Ratio Affects Loan Amounts
During the application process for your loan, three ratio tests will be used: debt-service coverage, loan-to-value, and debt yield. The loan that you receive must satisfy all three ratio tests. While application of one ratio may lead to a higher maximum loan amount than the others, the amount that is approved will be a more conservative amount.
Even after you secure financing, it is important to monitor your DSCR as a decline may put you in violation of your loan agreement. Borrowers with a low ratio are at a higher risk of being unable to cover their debt, particularly if they experience a decline in cash flow. In some instances, lenders require these borrowers to maintain a minimum DSCR during the course of the loan term.
Calculating your DSCR will help you to understand how lenders will view your commercial loan request. If your ratio is not at a level with which you or the lender is comfortable, it is important to take the necessary steps to improve it as it is a key indicator of the health of your business.