Debt Service Coverage Ratio 'DSCR'

What Is DSCR and Why Is It Important?

Debt Service Coverage Ratio (DSCR) is a key underwriting term that determines the minimum net operating income (NOI) required to cover the annual loan payments. Typically set around 1.25, the DSCR ensures borrowers have a financial cushion beyond their debt obligations. A DSCR of 1.25 means that the NOI must be 125% of the annual loan payments. This ratio varies slightly based on industry, market conditions, and property type.

How DSCR Impacts Lending Limits

DSCR sets a clear limit on the risk a lender is willing to take. By requiring a buffer in NOI, it prevents borrowers from being over-leveraged and ensures they can comfortably meet debt obligations.

Example: Calculating DSCR

Let’s look at an example with the following assumptions:

- Property’s NOI: $100,000

- DSCR requirement: 1.25

Using the formula DSCR = NOI / Annual Debt Service, we find the maximum annual debt service to be $80,000 ($100,000 ÷ 1.25). This equates to a maximum monthly loan payment of $6,667.

Adjusting for Interest Rates and Amortization

If interest rates or amortization periods change, the loan amount adjusts to maintain the DSCR. For example:

- At a 6% interest rate and 30-year amortization, the maximum loan amount is $1,112,000.

- If the interest rate rises to 7%, the maximum loan amount drops to $1,000,000.

- A shorter amortization period (25 years) at 7% further reduces the loan amount to $943,000.

Key Takeaways

1. DSCR ensures borrowers have a financial cushion by requiring NOI to exceed loan payments.

2. Rising interest rates or shorter amortization periods reduce the allowable loan amount.

3. DSCR is critical for balancing lender risk and borrower sustainability.

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