Commercial Loan: Asset vs. Repayment

Chris Gallant Uncategorized

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 least-understood 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 self-management, 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 re-calculate 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.


About This Location/Listing

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 least-understood 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 self-management, 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 re-calculate 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.

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