Debt Service Coverage Ratio (DSCR)

Debt Service Coverage Ratio, or DSCR, is a measurement of a property’s cash flow versus its debt obligations. In multifamily real estate, that entity is typically an income-producing property. The rule of thumb is that when an entity is shown to have a DSCR of less than 1, then that means that its income is less than its monthly debt obligations. In contrast, if a property has a DSCR of exactly 1, then that means its income is equal to its monthly debt obligations. Finally, when a property has a DSCR of more than 1, it means its income is greater than its monthly debts. Most apartment loan programs have DSCR minimums in place that help to determine eligibility.

DSCR Calculator

The DSCR Formula

In order to calculate the debt service coverage ratio for a multifamily property, you can use the formula: Net Operating Income/Debt Obligations. It’s essential to make sure you have ALL of the correct numbers before utilizing the formula.

Net Operating Income (NOI) for the DSCR formula is calculated using EBITDA (earnings before interest, tax, depreciation, and amortization), so it’s essential to understand this when calculating the annual DCR/DSCR for an apartment property. Debt Obligation encompasses all debts (recurring and outstanding) to be paid by the entity, usually calculated annually.

So, for example, if a property has an NOI of $1,000,000, and an annual debt obligation of $850,000, it would have a DSCR of:

1,000,000/850,000 = 1.18x DSCR

DSCR in Relation to Apartment Loans

When a lender is evaluating a borrower for an apartment loan, the debt service coverage ratio is typically one of the most important factors, if not THE most important factor that gets considered in a loan transaction. Lenders scrutinize a property's DSCR as one of the best predictors of whether a borrower will be able to pay back a loan sum. Many apartment loan programs set their minimum DSCR requirement at 1.25x, though in practice, the required DSCR will typically depend on the financial strength of the borrower, the type of property in question, and other key factors.

What else is DSCR used for?

The DSCR metric represents the amount of export earnings needed by a country to cover the annual interest and principal payments on its external debt In the context of government finance. In the context of personal finance, a person's DSCR is used by bank loan officers to determine eligibility for income property loans.

Regardless of the context, however, the debt-service coverage ratio reflects the ability of an entity to service debt considering their current level of income. The ratio takes into account net operating income against debt obligations due within one year. The debt obligations that are considered are numerous, including interest, principal, lease payments to name a few.

Lenders across the finance sector routinely assess a borrower's DSCR before approving a loan. The debt-service coverage ratio in conjunction with other standard underwriting criteria helps them determine the level of risk involved in originating a loan, with DSCR specifically representing the borrower ability to afford covering the debt. The minimum DSCR required by a lender often depends on current macroeconomic conditions. In a healthy, growing economy, credit is more readily available, and borrowers are more likely to get approved for a loan. with a lower ratio. 

The 2008 financial crisis, however, has shown the possible repercussions of what happens when there is a trend of lending to less qualified borrowers. The brunt of the crisis formed when subprime borrowers were able to obtain near unchecked credit in the form of mortgages, with very little due diligence. Ultimately, these under-qualified borrowers began to default on these mortgages, causing the financial institutions that financed these notes to collapse.

What is a good DCSR?

The most important thing to remember is that a “good” DSCR depends wholly on the requirements of the lender for the loan product in question. A widely accepted standard, however, is that a DSCR above 1.25 is often considered “strong,” and DSCR ratios below 1.00 are decent indicators that the borrower may be facing some financial hardships. This is because a DSCR of less than 1.00 reflects a negative cash flow, which, to lenders means that the borrower will be unable to cover the costs of their debt obligations without needing to borrow more.

In practice, a DSCR of 0.93 equates to the borrower only having sufficient income to cover 93% of their annual debt obligations. To a lender, this represents extremely high risk, as this metric basically shows that the borrower will need additional income to be able to make payments towards their debts. Even then, If the debt-service coverage ratio is higher than, but still too close to 1.0, then the borrower is considered to be vulnerable, as any minor decline in cash flow could render them unable to service their debt. 

For these reasons, the majority of Lenders in many cases require that the borrower maintain a minimum DSCR to qualify, and sometimes even a DSCR threshold while the loan is outstanding. In these cases, a lender will consider a borrower who falls below that minimum to be in default.