Debt Coverage Ratio – A Lender’s Most Important Number
The debt coverage ratio (DCR) is the most important number to your commercial real estate lender for several reasons. Lenders are the most important partner in your real estate deals because they typically provide the largest capital stack and lowest capital cost. As such understanding DCR is an essential element of deal analysis for experienced real estate investors.
In this article I’ll explain what it is; why it’s important and factors that affect it. This writing is from a commercial real estate perspective; which, factors the income generated by the real estate rather than residential real estate which factors the borrower’s income. It’s also commonly known as Debt Service Coverage Ratio (DSCR). Both terms mean the same thing.
What is Debt Coverage Ratio:
Lenders want to make sure your property can pay the mortgage. Debt coverage ratio (DCR) is the number that lets your lender know if your deal makes enough money to pay the monthly mortgage payment. DCR is expressed as a ratio between the net operating income (NOI) and the annual debt.
Below is an example and formula using numbers from an actual deal:
NOI = $304,296 • Annual Debt = $210,540
Formula = $304,296 (NOI) ÷ $210,540 (Debt) = 1.44 DCR/DSCR
In the example above think about this as the property generating enough income to cover 144% (1.44 debt coverage ratio) of the annual debt. From the lenders perspective the property generates enough income to pay the monthly mortgage and put money back in the borrower’s pocket.
* Note *
A DCR of 1.0 means all income goes towards paying the loan. Nothing else is left for the borrower – not a good scenario for either borrower or lender.
A DCR of less than 1 means the property is losing money and not generating enough income to pay the monthly mortgage.
What affects Debt Coverage Ratio?
Several factors affect DCR. All lenders have a minimum DCR but debt markets fluctuate. As a result we routinely check with our lending partners to review deals and be up to date on terms. This ensures our deal analysis is at current market parameters and not obsolete.
The amount of leverage or Loan-to-Value (LTV) can adversely affect the debt coverage ratio (DCR) if the property is underperforming. If the maximum LTV does not meet the lenders minimum DCR requirement, the lender will reduce the loan amount to meet its minimum DCR requirement. This is why understanding DCR is important as it’s a pivotal parameter from which other loan terms (leverage, interest rate, etc.) are tied to. If you’re offer on a deal is based only on LTV without regard to DCR, you’ll be wasting time making offers that are not lendable.
For multifamily deals in most markets with good populations, the typical DCR is a minimum of 1.2 to 1.25 (subject to change at any time).
Based on our experience below are factors we’ve encountered that affect DCR (all subject to change):
- Down payment. The higher the down payment, the lower the debt; which, equals to a higher DCR. Lenders see this as a safer loan. This may also provide better interest rates depending on the loan product.
- Location: Prime markets typically allow for lower DCR because lenders see them as safer due to their population and diverse economy. Cities with smaller populations and/or less diversified economy may require a higher DCR to adjust for the perceived higher risk.
- Agency lenders sometimes offer different terms for properties that cater to lower-income demographics. These terms may include a lower DCR.
Debt Coverage Ratio is important to any lender. It informs the lender of your deals capacity to pay the monthly mortgage. Calculating it is simple and straight forward. As an investor it’s essential to understand DCR and properly include it into any analysis involving debt. Knowing this and communicating your understanding of your deals DCR will give lenders further confidence that you’re a borrower they should lend to.