Debt Service Coverage Ratio Defined

Debt Service Coverage Ratio is a measure of the cash flow available from a piece of real estate or a business; and its ability to pay their current debt obligation, in real estate in the form of mortgage and business in the form of a loan. To understand this ratio further, let’s take a look at what goes into calculating this metric. 

The formula:

Debt Service Coverage Ratio = Net Operating Income (NOI) / Debt Service

To get the net operating income, that means the income generated from the operations of the property example is an apartment building. All the income from the apartment building in the forms of rent and fees is gross operating rent. It’s going to generate a certain amount of money and it’s going to cost a certain amount of money to run the property which include things like utilities, gas, property taxes, property insurance, HR and paying staff. These are all expenses of the property. So you take the gross income, all the rent, minus the expenses, and that gives you your Net Operating Income, or NOI. 

The debt service, on the other hand, is when you borrow money to buy real estate and that’s called leverage. When you leverage and buy real estate, you borrow money from the bank and to borrow money from the bank, one has to make mortgage payments on that loan. Those monthly mortgage payments are the debt service or monthly debt service obligation. If the monthly debt service obligation times 12 is for the year, take the yearly net operating income divided by the total amount of money that you’ll have to make in mortgage payments to the lender to arrive at your DSCR, or Debt Service Coverage Ratio. 

Why and how is this important? It’s important because it allows lenders, mortgage, banks, any type of lender to know the financial capability of a particular property to pay back its obligations in terms of debt. 

Say we had a 25-unit apartment building, and after all the expenses, the net operating income for this property is $100,000 at the end of the year we still haven’t paid off our lender. Say that the net operating income is $100,000, but the cost of servicing the debt is also  $100,000 which means we take our full $100,000, give it to the bank, and we’ve covered our debt obligations for the year. That would have a debt service coverage ratio of 1.0. 

Now, what happens if our debt service for the year is $120,000, or $10,000 a month, but our income is $100,000? We’re not bringing enough income to service the debt. What happens to the ration? It goes below 1 and becomes 0.83.  Say the property generates  $100,000, but interest rates are low, and the debt services only cost $80,000.  That debt service coverage ratio is 1.25. It’s above 1 when the amount of money exceeds how much money we need to cover our debt. 

Another example, it only costs us $35,000 to finance this property. In this scenario, we still make $100,000 on the property but the cost of our debt is only $35,000 and the ratio is 2.86.  Now which ratio are you most comfortable to lend on– in a ratio where the property is making less money than they got to pay you, or where they’re making almost three times the money that they need to pay you? 

In the world of multifamily real estate, the minimum ratio– and even in a lot of residential homes, a lender wants to see a ratio of at least 1.25 or greater.  Even if economic conditions changed in a unfavorable manner, and the income from this property went down a little bit, the ratio would go down, but they would still feel comfortable that even if it were to decline by 10% that this property would still be able to make its monthly obligations.