Commercial Magazine

Not An Exact Science

How the debt-service-coverage ratio is calculated can make or break your loan application

By Rob Diodato

You are originating a new commercial real estate loan. You gather all the required information and run the numbers to ensure the debt-service-coverage ratio (DSCR) demonstrates that your borrower has the necessary cash flow to cover the debt at the requested level. You scour your lender list to find the best match and send the deal to a lender, awaiting a letter of intent in return.

But lo and behold, your lender comes back with a different DSCR, which results in a lower loan amount. Now what? Time and effort has been wasted. An anxious client awaits terms. Your calculations are accurate, but you and your lender have come up with different numbers. How could that be? The answer is that the DSCR calculation is not an exact science.

One would think calculating DSCR should be as simple as plugging in the applicable rental income and expenses from the property’s vacancy data and its actual expense reports. It is not that simple, however. Lenders calculate the debt-service-coverage ratio in a range of ways and this can spell the difference between an accepted deal or a lost client. And the math can vary dramatically.

The DSCR is the relationship of a property’s annual net operating income (NOI) to its annual mortgage debt service (principal and interest payments). For example, if a property has $125,000 in net operating income and $100,000 in annual mortgage debt service, the DSCR is 1.25. A higher DSCR typically means that the borrower has a greater cash cushion to service the debt. It tends to qualify the borrower for a larger loan amount.

Key metrics

For almost all lenders, the debt-service-coverage ratio is the primary method for determining a borrower’s eligibility. It is a key metric, but it is not the only one. The property type, geographic location and loan-to-value (LTV) ratio all have to meet that lender’s requirements. DSCR is normally limited to investment properties. For owner-occupied properties, lenders tend to more closely evaluate the net operating income of the business to ensure that the business can service the new debt.

It is important to understand that there are other qualifying ratios that can adversely impact a commercial real estate loan application. In addition to meeting minimum DSCR standards for your lender, most lenders also now look at global cash flow. Even though your borrower may meet the minimum DSCR requirements, if your client’s global cash flow does not adhere to what is normally a one-to-one ratio that ensures the borrower has enough cash to pay off their debt obligations, you do not have a deal. So, you also must weigh a client’s income and liabilities when submitting a loan request.

That being said, DSCR is a fundamental metric in almost every commercial real estate deal. The calculation can be influenced significantly in three general ways.

Crunching numbers

First, lenders can assume vastly different vacancy rates for a property. There are no set of rules that lenders use to determine a standard vacancy factor. The assumed vacancy rate can be anywhere from 3% to 10%, so mortgage brokers need to be careful when applying a vacancy rate in their calculation of DSCR.

Normally, lenders assume a vacancy rate of 5% for a residential-investment property, and 10% for an office, retail or industrial property. Mixed-use properties can further complicate the DSCR calculation, given the mix of commercial and residential uses. Some lenders will apply a 7% vacancy factor for the entire property, while others may use a 5% rate for the residential units and 10% for the commercial component.

The key point is that the assumed vacancy rate can have a dramatic impact on DSCR. The higher the assumed vacancy factor, the lower the net operating income. Again, you should ask the lender about their assumptions before submitting your application, so you can feel confident that the loan meets that lender’s requirements.

The DSCR also can fall below a lender’s minimum standards if the lender assumes higher property expenses. Some lenders use a set expense factor rather than the numbers that are reported as expenses on the tax documents used by individual owners, partnerships or corporations. This expense factor can range from 30% to 40% of the gross income from rents that are collected, and it can prove to be much higher than the actual expenses. Brokers should be wary of lenders that automatically assume high property expenses in their calculations.

Some lenders use historical expense reports, but include items that other lenders will ignore. For example, some lenders include reserves for costs such as maintenance, legal and property-management fees. These items can throw a DSCR out of whack and cause the deal not to qualify. Assuming higher annual property expenses will lower DSCR and the other primary values used to calculate the loan-to-value ratio. All of these factors will ultimately determine a borrower’s eligibility for a loan at the requested level. Be sure to have your lender itemize which expenses will be included in their calculations, so that you are not taken by surprise later on and left scrambling to find a home for your loan.

Some lenders also use stress testing to assess how the property might perform under hypothetically adverse conditions. This is a less common practice, but it still can be a reason for a loan not qualifying. In determining eligibility, for example, lenders may apply a higher interest rate of as much as 2%, or they may use a higher qualifying debt-service- coverage ratio. Stress testing offers lenders another degree of security for a commercial real estate transaction, but it can hamper your ability to get otherwise solid transactions qualified.

Alternative methods

Sometimes a property’s DSCR falls below minimum thresholds for any conventional lenders, regardless of what methodology is used. Your borrower has to look for other options. Many nonbank lenders, however, either do not use DSCR or use an abbreviated calculation.

Although many lenders will strictly limit these loans to residential-investment properties, some will offer them on other types of commercial property. Due to the higher inherent risk, these loans normally carry much higher interest rates, but they allow a borrower to purchase a property and raise rents. The borrower can then refinance the loan at a later date under more favorable terms.

You will need to do your homework prior to choosing a path for deals that fall within these parameters. These products fill a void and can enable you to close more loans that may not qualify with conventional lenders. These loans also can present an alternative to hard money or bridge financing, which can carry even higher rates and fees.

• • •

Lenders calculate DSCR in various ways. One lender may qualify a loan with a higher rate and shorter amortization. Another lender that calculates DSCR differently may offer a lower rate and a longer term. Get to know how your lenders qualify borrowers and keep the information handy. This knowledge can help prevent delays and should ultimately help your client get the best deal.


  • Rob Diodato

    Rob Diodato is the president of York Commercial Finance, a commercial mortgage advisory company with offices in Dallas and New York. Diodato arranges financing for commercial real estate transactions nationwide for all property types. Diodato has more than 26 years of experience in the commercial and residential mortgage industries.

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