A Different Coverage: Understanding DSCR
February 23rd, 2023 · 5 min read
What is the DSCR?
The debt service coverage ratio (DSCR) or debt coverage ratio is the measure of operating income available to service debt for interest, lease payments and principal. The DSCR is a benchmark metric of measuring an individual’s or entity’s capability to produce enough liquidity to cover debt payments. It also stands as a good measure for an individual or entity to measure their net operating income, as it is one of the primary metrics needed to calculate the DSCR. Understanding the debt service coverage ratio can be a great first step in evaluating an individual or entity’s viability of acquiring proper financing.
How to Calculate the DSCR
To calculate the debt service coverage ratio, you must take your annual net operating income and divide it by your annual debt service.
- DSCR = Net Operating Income / Total Debt Service
The net operating income is calculated as the gross income minus all of the operating expenses. The debt service is simply the summation of all current debts including your principal and interest. The only complicated caveat to calculating a proper DSCR is income taxes, because principal repayments are not tax deductible; whereas, interest payments are.
A way to more accurately solve for this caveat is to calculate your total debt service as the interest multiplied by one minus the tax rate and the add principal as seen below.
- Total debt service = (Interest x (1 – Tax Rate)) + Principal
Some lending entities may use the EBITDA or EBIT methods for calculating the DSCR. EBITDA stands for earnings before interest, taxes, depreciation and amortization. This method is not typically calculated on an entity’s income statements as it isn’t a general metric recognized by the GAAP (Generally Accepted Accounting Principles).
- EBITDA = Net Profit + Interest + Taxes + Depreciation & Amortization
In determining what the standard is for a DSCR can vary company to company based on industry, competitors and growth stage. Generally, a DSCR of 1.25 or above is considered the bar, whereas companies with a DSCR below one can be considered as having financial difficulty. Many lenders have set their minimum DSCR as 1.25 as a part of their minimum loan requirements.
The DSCR’s Impact on Commercial Real Estate Investing
The debt service coverage ratio is an integral metric when seeking financing, and one that lenders will use in their process of determining if the property is cash flowing and the deal ultimately makes sense. Especially in times of higher interest rates and economic adversity, lenders want to take less risks. Lenders want to make absolutely sure that they can recuperate the funds they are expending through a loan. Keep in mind, as you are investing in commercial real estate, a lender is also “investing” in you. Therefore, incorporating an accurate as possible calculation of your DSCR into your financing strategy is imperative to acquiring the appropriate loan for your investing needs.
Something to keep in mind is that lenders can differ in how they calculate the debt service coverage ratio. As referenced before, some lending entities may prefer to use the EBITDA or EBIT calculation as the numerator to calculate the DSCR, so having a plan for this is yet another tool to bring to the table when trying to get proper financing.
In addition to EBIT, Lenders will also vary in calculation on some fixed-expense items such as the stress interest rate, pro-forma and other values that can change over time.
Having a good debt service coverage ratio can help investors attain:
- Higher loan approval odds
- Lower interest rates on loans
- More variety in financing options
- Improvement with your own internal operations
It is often advantageous for individuals or entities to consult with a financial specialist in determining the proper calculations for their debt service coverage ratio.
Other important metrics used in underwriting for you to consider are:
- Internal rate of return (IRR)
- Debt yield
Where Terrydale Capital Comes In
When you need to formulate a financing strategy for your commercial real estate investing needs, contact us at Terrydale Capital. Our primary goal is to help our clients achieve their investing goals by guiding them in the right directions and using our widespread connections to a variety of lenders, brokers and institutions. Even in times of economic adversity where achieving financing may seem impossible, Terrydale Capital is poised to help.
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