|
MORTGAGE 101
Commercial Loan Debt Service Coverage Ratio
(DSCR)
The most important ratio to understand when
making income property loans is the debt service coverage ratio. It
equals Net Operating Income (NOI) divided by Total Debt Service. To
understand the ratio it is first necessary to understand the numerator
and the denominator. Let's take a look at net operating income (NOI)
first.
Net operating income is the
income from a rental property left over after paying all of the
operating expenses:
|
Gross Scheduled Rent |
$100,000 |
|
Less 5% Vacancy & Collection Loss |
$5,000 |
|
|
________ |
|
Effective Gross Income: |
$95,000 |
|
Less Operating Expenses |
|
|
Real Estate Taxes |
|
|
Insurance |
|
|
Repairs & Maintenance |
|
|
Utilities |
|
|
Management |
|
|
Reserves for Replacement |
|
|
Total Operating Expenses: |
$30,000 |
|
Net Operating Income (NOI)
|
$65,000 |
Please note that lenders always insist on some sort of
vacancy factor regardless of the actual vacancy rate in an area to
cover collection loss. In addition lenders always insist on using a
management factor of 3-6% of effective gross income, even if the
property is owner-managed. Their logic is that they would have to pay
for management if they took back the property. Finally, NOTE THAT WE
HAVE NOT INCLUDED LOAN PAYMENTS AS AN OPERATING EXPENSE.
Next let's look at the denominator, Total Debt
Service. This includes the principal and interest payments of all
loans on the property, not just the first mortgage. NOTE THAT WE HAVE
NOT INCLUDED TAXES AND INSURANCE. They were already accounted for
above when we arrived at net operating income (NOI).
To calculate the debt service coverage ratio, simply
divide the net operating income (NOI) by the mortgage payment(s). For
the sake of simplicity, let us assume that there is only one mortgage
on the property:
$500,000 First Mortgage
11% Interest, 30 years amortized
Annual Payment (Debt Service) = $57,139
Then:
DSCR = Net Operating Income (NOI) = $65,000
Total Debt Service $57,139
DSCR = 1.14
Obviously the higher the DSCR, the more net operating
income is available to service the debt. From a lender's viewpoint it
should be clear that they want as high a DSCR as possible.
The borrower, on the other hand, wants as large a loan
as possible. The larger the loan, the higher the debt service
(mortgage payments). If the net operating income stays the same, and
the loan size and therefore the debt service increases, then the lower
the DSCR will be.
Life insurance companies are very conservative and
generally require a 1.25 or 1.35 DSCR. This means that their
loan-to-value ratios are low. Savings and loans (S&L's) generally only
require a 1.20 DSCR, and sometimes will accept a DSCR as low as 1.10.
A DSCR of 1.0 is called a break even cash flow. That
is because the net operating income (NOI) is just enough to cover the
mortgage payments (debt service).
A DSCR of less than 1.0 would be a situation where
there would actually be a negative cash flow. A DSCR of say .95 would
mean that there is only enough net operating income (NOI) to cover 95%
of the mortgage payment. This would mean that the borrower would have
to come up with cash out of his personal budget every month to keep
the project afloat.
Generally lenders frown on a negative cash flow. Some
lenders will allow a negative cash flow if the loan-to-value ratio is
less than around 65%, the borrower has strong outside income such as
an electronic engineer, and the size of the negative is small. Lenders
rarely allow negative cash flows on loans over $200,000.
|
