When borrowing money for a commercial loan or mortgage, the first thing that a lender considers is repayment, not asset. The lender needs to know that you can service the debt. They use what’s known as a DSCR or Debt Service Coverage Ratio to determine it. The debt service coverage ratio is one of the leastunderstood underwriting requirements. Briefly, the DSCR simply compares the subject property’s net operating income to the proposed mortgage debt service (on an annual basis).
The Math Behind DSCR
Understanding the concept and math behind the Debt Service Coverage Ratio for a prospective commercial loan is important. This is true whether it’s a purchase or refinance. If the property is operating more efficiently than comparable properties (due to selfmanagement, not keeping up with R&M, etc.), or not including a minimum vacancy percentage, both the underwriter and appraiser will use a vacancy factor and bring expenses in line with the market.
This reduces the net operating income (NOI) thereby lowering the DSCR and loan amount. The appraisal will be used as a secondary factor. In other words, first, the DSCR will be calculated, then the value will be considered. Other considerations are, what did you purchase the property for (for refinancing), what is the property selling for (if you are making a purchase), and who performed the appraisal.
Commercial Loan Calculation Example
Below is a basic example of how a commercial lender calculates the DSCR for a loan or mortgage. The example (expenses and other are estimated) is based on purchasing a 12 unit building for the price of $900,000.
Income 

Gross Potential Rents 
$107,000 
Other Income 

Total Annual Gross Income 
$107,000 
Less 5% Vacancy & Collection Loss 
$5,350 
Effective Gross Income: 
$101,650 
Expenses 

Real Estate Taxes 
$12,000 
Property Insurance 
$5,000 
Repairs & Maintenance 
$5,000 
5% Off Site Management Reserve 
$5,082 
Replacement Reserves Estimated at $200 Per Unit @ 75 Units 
$2,400 
Total Operating Expenses: 
$29,482 
Net Operating Income (NOI) 
$72,168 
Now that we have calculated the NOI, we must calculate the annual debt service for the property. The annual debt service is simply the total amount of principal and interest payments made over a 12 month period. Taxes and insurance are not included in this calculation as they are accounted for in the expenses of the property.
Calculating the DSCR
To calculate the debt service coverage ratio, simply divide the net operating income (NOI) by the annual debt.
Commercial Loan Size: $900,000
Interest Rate: 6.5%
Term: 30 Years
Annual Payments (Debt Service) = $67,656
Net Operating Income (NOI) = $72,168
Now we can calculate the DSCR:
DSCR = Net Operating Income / Annual Debt Service
(NOI) = $72,168
Total Debt Service = $67,656
DSCR = 1.07 ($72,168 / $67,656)
What the Example Tells Us
What this example tells us is that the cash flow generated by the property will cover the new commercial loan payment by 1.01x. This is generally lower than most commercial mortgage lenders require. Most lenders will require a minimum DSCR of 1.20x.
If a DSCR is 1.0x, this is called breakeven, and a DSCR below 1.0x would signal a net operating loss based on the proposed debt structure.
How to Get the DSCR up
So, how do you get the DSCR up? Well, either you get the price of the building down, or, you have a downpayment of at least 20% or more. So let’s say the price stays the same, but, you put down 25% ($225,000), what happens to the DSCR?
Commercial Loan Size: $675,000 ($900,000$225,000)
Interest Rate: 6.5%
Term: 30 Years
Annual Payments (Debt Service) = $50,736
Net Operating Income (NOI) = $72,168
Now we recalculate the DSCR:
DSCR = Net Operating Income / Annual Debt Service
(NOI) = $72,168
Total Debt Service = $50,736
DSCR = 1.42 ($72,168 / $50,736)
Now the loan can be serviced given your DSCR of 1.42
Contact me today if you would like assistance with your commercial loan.