Debt Service Coverage Ratio (DSCR) otherwise known as the debt coverage ratio (DCR) is one of the main tools that lenders use when deciding whether to make a particular loan.
A simple example of how DSCR is calculated is as follows:
= Net Operating Income
Total Debt Service
A ratio that is above 1/1 would show that the borrower has excess income to meet continuing obligations plus the payments any loan that the lender is contemplating giving. A ratio below 1/1 would mean that there is not enough income to support the proposed debt along with existing obligations.
The vast majority of lenders describe themselves cash flow lenders this would include pretty much all the banks, credit unions, life Insurance companies, etc. In order to get a loan from a cash flow lender a ratio in excess of one is a requirement.
Most borrowers who find themselves with a DSCR below one end up with a private money loan. This is often called “Hard Money” and rightfully so as the rates and fees are significantly above that of a cash flow lender.
Different banks have different DSCR requirements and depending upon the specifics of any transaction the required DSCR could be higher or slightly lower. Generally speaking those lenders that offer the lowest rates would like to see a higher DSCR than those lenders with higher rates. Not always, but in general the lower the rate the harder it is to get the loan. It is a reasonable assumption that most national banks look for a DSCR approximating 1.25/1 at a minimum.
Occasionally an SBA lender will consider a loan to a borrower who has existing financials that show a DSCR below1/1 if the borrower has a reasonable projection showing the ability to make loan payments. An example of this would a business that purchases a property to expand their existing business. The income to pay the loan will come from the new location and would not be shown in existing financials.
With investor properties some lenders look at two DSCRS. One for the property being lent upon and another that would include the property and the borrower as well. The DSCR for the borrower and the property is known as the Global DSCR or Global cash flow. The common practice is for a lender to require a Global DSCR to be slightly higher than the property DSCR. An example would be if the DSCR for the property was 1.25/1 a lender would also like to see a global DSCR of 1.35/1.
When dealing with owner user real estate the global cash flow is the only relevant DSCR.
Please note that there are exceptions to what I have written above. They cost money.
Why this is important
The debt coverage ratio impact a borrower’s ability to get a loan at reasonable terms and conditions. Private money rates can at least three percent higher than conventional rates and usually significantly more.
What you can do about it
When looking the above ratio for DSCR the denominator (part that is below the line) consist of total debt service. The smaller that number is the greater the loan that you will qualify for from a cash flow lender.
1. Prior to applying for a loan pay off all your credit cards. Banks often take a percentage of your total balance and it to your total debt service. This amount varies from lender to lender but can be up to three percent per month of your total balance. For example, if you $10,000 in credit card debt a lender would assume $300 in monthly payments.
2. Buy or refinance your commercial real estate before you make any purchases that require monthly payments. Every dollar in monthly payments that a borrower has is added to the denominator.
3. To the vast majority of lenders the most important year for the DSCR is the last year that they have tax returns or audited financial statements. So if you a planning on purchasing or refinancing commercial real estate in 2014 you want your 2013 taxes to look good even at the expense of a prior year’s tax return.
Simple example of how this would affect your ability to get a loan
Let’s say a major bank is looking at making a loan on your property at about a 6% annual interest for a thirty year term.
You have $15,000 is credit card debts and you just got nice car with a $550 monthly lease payment.
A lender could assume a monthly cost to you for the credit card debt to be $450 per month and with the $550 lease payments you have $1.000 monthly expenses.
If you waited to get a new car and used your excess money to pay off you credit cards you could be able borrower in excess of $150,000 more.
Note for Investor Properties
1. Be sure to review all your expenses for the previous years. If there are any expenses that are one-time expenses not to be repeated you should notify the lender as this money could be added back to your cash flow.
2. Try to time any leases so that they do not expire shortly after your loan term ends. There are two reasons for this:
a. Banks like to see a long term cash flow when making a loan.
b. Hopefully the current income for the property will be higher than the previous income.
If you have any questions regarding commercial real estate loans please give me a call. I am actively working on conventional commercial real estate loans and SBA loans. I have over a quarter century of experience and would be pleased to see how I could help.
Pacific West CDC