Commercial Loan - What is Most Important Ratio?

[Karen Schimpf]

by roger4336

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.

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Net operating income is the income from a rental property left over after paying all of the operating expenses:

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	$10,000
Insurance	$ 2,000
Repairs & Maintenance	$ 3,000
Utilities	$ 3,000
Management	$10,000
Reserves for Replacement	$ 2,000
___________ 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.

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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
5% Interest, 30 years amortized
Annual Payment (Debt Service) = $32,210

Then:
DSCR = Net Operating Income (NOI) = $65,000
Divided by the Total Debt Service $32,210
DSCR = 2.02

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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 1.35 or 1.5 DSCR. This means that their loan-to-value ratios are low. Typical commercial lenders generally require a 1.25 DSCR or higher depending the type of property and the location.

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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.

Conventional lenders frown on a negative cash flow. There are some lenders (hard money lenders) that will allow a negative cash flow if the loan-to-value ratio is less than 65%-70%. The hard money lender would need something strong about the file. A strength could be the borrower has strong outside income or a lot of liquid assets etc. Hard money loan requires the borrower to have an exit strategy of how the loan is going to be paid off or refinanced in 3 to 36 months.
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Wishing You the Best,

Karen Schimpf
Commercial Capital, Ltd.
p: 512-650-8630
e: KarenSchimpf at gmail.com
www.linkedin.com/in/karenschimpf/
blog: http://bizloansconnections.com/website: http;//applycommercialloans.com

P.S. I specialize in SBA and Alternative Commercial Loans. I help entrepreneurs attain financing for their business or project. I BRING MONEY FROM AROUND THE COUNTRY TO LOCAL MARKETPLACES INSURING THE MOST LIKELIHOOD OF CLOSING. The key is placing the borrower with the lender that most suits that borrower's strengths. I do it better than anyone. Give me a call today at O:512-650-8630 or C:512-354-5949 to get your loan closed.