Many new commercial real estate investors find it difficult to understand all the different parameters and terms used in the industry. In fact, there are even many experienced professionals who do not have a clear understanding of what these measurements really mean. The debt service coverage rate is one of the most important concepts in commercial real estate.

Each commercial lender will carefully consider this metric when assessing whether or not your property qualifies for a commercial mortgage. It is therefore up to you, as an investor, to fully understand what this ratio consists of. If you don’t feel completely comfortable with this concept, read on. This article is for you.

The debt service coverage ratio is the relationship between a property’s net operating income and its annual mortgage payments in principal and interest or debt service. Consider the following example. An apartment building in Chicago generates $ 250,000 in net operating income. The owner of this property pays annual principal and interest payments of $ 200,030. This property’s debt service ratio is just under 1.25 (1.249). Let’s take a closer look at this example to really explain how to calculate the debt service coverage ratio. The following income statement details the annual income and expenses of the above building:

After calculating the total gross income and deducting the operating expenses, we see that the property generates $ 125,000 in net operating income. Now let’s talk about the mortgage payment on the property.

Assume the following loan terms: With these numbers in mind, we can now calculate the debt service coverage ratio for this apartment building. Remember, this property generates $ 250,000 in net operating income and the borrower must pay $ 200,030 in debt service annually. To determine the debt service ratio, you simply divide the NOI ($ 250,000) by the debt service ($ 200,030). As mentioned above, this equates to around 1,249. But why is this metric important?

Well, it’s actually pretty straightforward. If you break this concept down even further, you’ll find that the DSCR for this property really tells us that the building generates around $ 1.25 in income for every $ 1 you owe the lender. If, for example, a property’s DSCR would be 1, that would indicate that the property is generating just enough money to cover mortgage payments, and if the DSCR is less than 1, it means that the property’s income is not cannot cover the loan terms offered.

Since commercial mortgages are primarily based on the cash flow of the property in question, lenders will always want to ensure that the property is generating enough net operating income to cover the debt service. This contrasts with residential mortgages where the debt-to-income measure is used. In the commercial space, lenders generally want to ensure that the income from the property itself covers the mortgage (aside from any outside income the borrower may have). In the event that unforeseen incidents occur during the life of the loan, such as a vacation or additional expenses, lenders want to ensure that the property actually generates more annual income than the annual mortgage payments. It is common in the commercial mortgage industry to look for a DSCR of at least 1.25 when taking out a commercial loan. If the amount of a proposed loan does not meet the lender’s minimum debt service coverage ratio, the debt service is considered limited and the lender will reduce the loan amount.

While most lenders only take property income into account when calculating the DSCR, some lenders provide commercial real estate loans on the basis of the “overall DSCR”. These lenders will take personal and real estate income and expenses into account when calculating the debt service coverage ratio. So if a property has low cash flow but the borrower has other additional income that brings their overall income above the lender’s debt service coverage ratio threshold, the loan will still be achievable. For example, if the property in the above case generated only $ 200,030 (at 1 DSCR) but the borrower has a part-time job that generates $ 50,000 in income, the service coverage ratio of the aggregate debt would meet the requirement of 1.25 DSCR.

One more thing to consider when calculating the debt service ratio is how lenders calculate expenses. Many borrowers only include the actual expenses of the property in their calculations. While it may seem intuitive, lenders usually don’t limit themselves to actual expenses when assessing the debt service ratio. Even if a property is 100 percent occupied, lenders will generally assume a vacancy factor of around 5 percent to protect against any potential future vacancies. Additionally, lenders typically incur a management fee of around 5% of actual gross income (even if the property is self-managed). Lenders do this because they have to take out loans based on the potential they will need to seize the property and hire a management company to manage the property. They have to make sure that the property will always generate enough income in such a situation. Finally, lenders often incur annual repair and maintenance costs of around $ 750 to $ 1,000 per unit (although the actual repair costs are much lower). It is really important to remember to calculate the debt service ratio based on how the lender will view it. After all, they are the ones who lend the money!

Stephen A. Sobin is the President and Founder of Select Commercial Funding LLC, a national mortgage brokerage company specializing in commercial mortgages and apartment loans.