Debt service coverage ratio determines the maximum loan payment based on a property's income, thereby also determining the maximum loan amount.
1. Debt Service Coverage Ratio = NOI / Debt Service
2. Maximum Annual Debt Service = NOI / DSCR
Example: $100,000 NOI / 1.25 DSCR = $80,000 Max Debt Service
Debt Service Coverage Ratio (DSCR) is an underwriting term used by lenders that effectively sets a minimum for the amount of net operating income available to cover the debt service. The ratio is often set right around 1.25 -- sometimes 1.2 or 1.3 -- depending on the industry, the market, the market timing, and the product type.
DSCR tells us how much extra cushion we need to have in our net operating income over the debt service or the annual loan payments. In this case, a 1.25 debt service coverage ratio means that the NOI needs to be 125%, or 1.25 times the amount of the annual loan payments. DSCR sets a limit on how much risk the lender's going to take in terms of what they loan compared to the cash flow on the property. They don't want to put borrowers in a position where they have barely enough net income to cover the debt service or, even worse, not enough net income, so the DSCR builds in the amount of cushion that they want. Lenders can adjust this for competitive reasons, or market reasons, but it typically is about .25 over the debt service amount.
Let's take a look at an example. Imagine a property has $100,000 of net operating income. If we look at our formula, if 1.25 is our minimum ratio, that means that 1.25 equals 100,000 divided by X, would make X = 80,000. This makes $80,000 our maximum annual debt service. We take that number, we divide it by 12, and we know that our maximum monthly loan payment is going to be $6,667.
Understanding this, if the DSCR dictates what our maximum loan payment can be, then one thing that we need to recognize is that our debt service amount that allowed by the lender is capped at $6,667. If interest rates go up the payment cannot go up beyond that, so if interest rates rise then the loan amount would have to go down in order for us to stay within the minimum required debt for service coverage ratio. Let's look at the numbers behind that.
If we've already determined that our debt service coverage ratio is a minimum of 1.25, and we have $100,000 in net income then we know that X, which in this case would be $80,000, is our maximum debt service per year, or $6,667 per month. Let me show you how this would be calculated in the face of changing interest rates, or perhaps a shorter amortization period. I'm going to lay this out the way we would lay it out in a financial calculator. If you haven't taken that lesson yet just check out our other videos on financial calculators, and calculating debt service, present value, etc.
Let's imagine we're punching this into our financial calculator. In this example, I'm going to use a 30 year fixed loan with monthly payments at 6% fully amortizing. We've determined that our maximum loan payment each month can only be $6,667. If we have a 6% interest rate, and we're doing a 30 year, or 360 month, amortization, we get a $1,112,000 maximum potential low.
Typically, if our net operating income is fixed, then our maximum loan payment is also fixed. If interest rates, in this case, should go up to 7% still amortized over 30 years, and knowing that our payment can't go up, this would bring our maximum loan amount to $1 million.
Similarly, if we still had a 7% interest rate, but our amortization was shortened to, say, 25 years, or 300 months, and our payments still capped at $6,667 then our loan amount would be reduced even further to $943,000. DSCR, again, tells us what the percentage of the net operating income over the annual debt service needs to be.
As we can see, annual debt service can be affected by both interest rates, and amortization. Most importantly, what we need to remember here is debt service coverage ratio lets us know how much extra net operating income we have over our loan payments.