the debt coverage ratio
How To Calculate The Debt Coverage Ratio For Your Real Estate Deal
When dealing with the debt coverage ratio and how it relates to commercial real estate, it is still one of the issues that many investors do not have a solid understanding of. DCR, or debt coverage ratio is comparing the property’s net operating income or NOI to the proposed mortgage debt service. The lender needs to know that there is sufficient cash flow to actually cover the debt within the new mortgage, with a little more on top, to boot. The lenders use this figure to determine what the actual coverage of income is within a certain loan amount. Two important factors used when looking at approval for commercial real estate loans are the debt service coverage ratio and the loan to value, or LTV. A property may appraise for enough to reach the lender’s Loan to Value ratio, but if the rents are not sufficient to meet the lender’s Debt Coverage Ratio, then you may have additional hurdles to overcome. Sometimes this happens in distressed properties where the underlining land or building is worth more, if renovated or redeveloped, than the current rents the property is producing would suggest.
One of the things that borrowers do not always fully understand is that the bank or commercial lender uses property related expenses when they are calculating the net operating income. Expenses such as off site management, vacancy, market expenses and actual expenses are what commercial lenders are really looking at when making their decisions about property. If the borrower goes through hard times and actually defaults, the commercial lender will add up these expenses when taking into consideration the entire cost if the property needs to be taken back.
To calculate the debt coverage ratio, you add together the gross rents and other income, yielding you the total annual gross income. Then you subtract the amount that is your vacancy and collection loss, for example 5%. Now you have the effective gross income, and subtract away your monthly expenses from that figure. Real estate tax, property insurance, repairs and maintenance, pest control, janitorial expenses, utilities, off site management, and the replacement reserves are all subtracted from this effective gross income. The effective gross income less the total operating expenses give you the net operating income or NOI, which is the main component of the debt coverage ratio calculation formula.
The other number you will need for the debt coverage ratio calculation is the annual debt service. The net operating income is divided by the annual debt service. For example, a net operating income of $800,000 divided by an annual debt service of $687,500 = a debt service coverage ratio of 1.16. If the number is over 1, you now know the property generates positive cash flow over and above the debt service and will cover the actual payment of the loan by 1.16x. When lenders in the current climate are making their final decision, they usually are looking for a minimum debt coverage ratio of 1.20x. When this figure is at a 1.0x, it is known as a “breakeven”, and anything below this threshold will warn you of negative cash flow. Gaining a better understanding of this calculation better prepares you to understand the lenders perspective in evaluating risk and underwriting loans.